Inflation momentum has slowed, but shadow of other macro concerns looms over MPC

After the Reserve Bank of India (RBI) hiked interest rates in August, our read-through of the minutes was that the monetary policy committee (MPC) can skip the October meet to assess the lagged effect of two back-to-back hikes. The two Consumer Price Index (CPI) prints after the August MPC have, in fact, turned out to be substantially lower than RBI’s estimate as food prices have not followed their seasonal pattern and even core inflation momentum has slowed. In the normal course of time, this inflation profile should have reconfirmed a pause in October, but, this time, other factors could change the mind of the MPC.

The October MPC will have to debate some conflicting issues which are beyond the traditional growth inflation trade-off conceived under the flexible inflation targeting framework. In its two-year anniversary, the MPC should be credited with the fact that CPI is close to its medium-term target of 4%. But, unfortunately, the shadow of other macro concerns loom. Structural current account deficit (CAD) and the funding of it, the weakening rupee and liquidity issues in the shadow banking system are all likely to prompt the MPC to think whether an explicit consideration of protecting financial stability is warranted within the flexible inflation targeting framework.

The obvious question remains why the MPC would need to hike rates when inflation is relatively under control. We do not think that the MPC is under much pressure to adopt an interest rate defence of the exchange rate as yet. Runaway depreciation fears have been arrested for now as the emerging market currencies receive a brief respite and signs of speculative positioning which would warrant punitive measures of sharp rate hikes are limited. However, the MPC could still play its part in controlling the CAD by extending a tightening bias to monetary policy and moderating the growth momentum. In our view, a durable solution to India’s current account problem would require exports to be rebuilt, but, till that happens, some restrain on growth is a safeguard to ensure a check on burgeoning non-oil, non-gold imports.

RBI has recently noted the closing down of output gap and in that backdrop, supply shocks like higher oil prices and rupee depreciation have the potential of raising inflationary expectations too. Household inflationary expectations have been on the rise in the last two surveys and the next one might buttress the trend. Early anchoring of these expectations would help RBI in achieving its CPI target on a more durable basis. Gradual rate hikes would also improve India’s relative positioning as interest rates globally are inching up faster than expected. Although real interest rates are much higher in India now compared to 2013, global fixed income investors could possibly switch their preference to other countries which are on the path of steady rate hikes.

In our base case, we expect a 25 basis points (bps) hike in policy rate but there is always the possibility of the MPC looking at the available evidence through a different lens. If the MPC focuses solely on inflation and doesn’t want to get embroiled in achieving multiple objectives of correcting macro imbalances and financial stability, then it might refrain from further tightening now. A pause could also be justified in the context of containing contagion from emerging tremors in India’s shadow banking system. However, a pause risks a sharp knee-jerk reaction in currency markets. On the other hand, we ascribe a low probability to a 50bps hike as it might indicate a panic response.

Closed output gap, successive rate hikes and the need for higher real rates might trigger a change in the neutral stance too.

If the stance changes, then the interest rate hiking cycle might be extended further. However, this could still be consistent with RBI providing ample liquidity through open market operation/term repos in the second half of the financial year to keep the overnight rate within the liquidity adjustment facility corridor.

Samiran Chakraborty is chief economist at Citibank.