Reserve Bank of India governor Urjit Patel. Photo: PTI
Reserve Bank of India governor Urjit Patel. Photo: PTI

Time for MPC to shift its policy stance

Adjusting the monetary stance sooner with a gentle pace of rate increases is tactically better than being forced into stepped-up tightening following a delayed shift in the stance

A key focus next week is the meeting of the monetary policy committee (MPC) of the Reserve Bank of India (RBI). Will it hike the policy repo rate again, after having caught most economists off-guard by raising it at the last meeting in early June? Further, will it shift to a tightening stance from the neutral position it has maintained since announcing it early last year?

The MPC will, more likely than not, avoid raising interest rates next week, in my view. The double whammy of outsized adverse moves in international crude oil prices and the rupee in the run-up to the June meeting has eased for now, though inflation concerns remain. Uncertainty over the global fallout from some of the actions of President Donald Trump also persists.

Domestically, the recently announced outsized increase in minimum support prices (MSP) is unlikely to tilt the scale in favour of a rate increase next week. This is because it is unclear if much of the revision will be translated into actual price increases. Market prices for most of the kharif crops for which the revisions were announced are reportedly below the respective MSPs.

What about the policy stance? The MPC shifted its stance to neutral from accommodative in February 2017. This followed unchanged rates after the prior cut in the repo rate, to 6.25%, in October 2016. Noticeably, the change in stance to neutral didn’t prevent the MPC from reducing the repo rate again in August 2017 to 6%, where it stayed until the increase in June this year.

The MPC chose to maintain the neutral stance in June despite coming across as confident about the underlying economic recovery, and despite signalling upside risk to inflation. The main motivation for sticking with the neutral stance was uncertainty regarding a few key variables, such as the international price of crude and local MSP revisions. These are understandable considerations. However, these uncertainties didn’t prevent the MPC from signalling upside risks to inflation, even after revising up its inflation forecast. Surely, if risks are so skewed that the MPC felt compelled to signal upside risk even after revising up the inflation forecast, the evolving pressures aren’t fleeting.

Hiking policy rates once or twice doesn’t contradict maintaining a neutral stance. But how many times can the MPC raise rates while still staying on neutral? Equally importantly, how long can the MPC continue with the neutral stance?

The MPC can probably raise rates once more while still maintaining its neutral stance. Beyond that it cannot keep flagging uncertainties to the outlook for staying on neutral while signalling upside risks to inflation and also increasing the policy rate. Such a mix will make a mockery of its guidance and credibility.

The statistical impact of the increase in house rent allowance (HRA) will soon begin to gradually dissipate. Volatility in India’s near-term inflation trajectory and some favourable base effect on inflation in 2019-20 aside, the clock is ticking for the MPC to shift its stance. Food inflation has been well behaved and the government deserves credit for it. However, there is no new institutional framework put in place which inspires confidence that this stability will be sustained and not just a propitious outcome of good luck and ad-hoc policy steps.

The MPC was caught unawares by the recent jump in household inflation expectations. Separately, core inflation remains well above headline CPI inflation, which, in turn, has remained above the 4% mark for eight straight months. Core inflation, adjusted for the HRA increase, has been rising even in the absence of a broad-based recovery. Admittedly, commodity prices have a major role to play here, but so does improving aggregate demand.

For an economy with the output gap almost closed, and one that is plagued with sector-specific excess demand imbalances and high unsatiated aspirational demand, there is high risk of a lasting rise in inflation. It’ll be too late if the MPC waits until corporate pricing power begins to strengthen meaningfully to shift its stance.

The MPC could take some cues about clearer communication from the board of the Reserve Bank of Australia, one of the most credible inflation targeters. While maintaining its neutral stance, the board has signalled that the next move in the policy rate would more likely be an increase than a decrease, even though it indicted there isn’t a strong case for a near-term adjustment. Essentially, the central bank doesn’t want financial markets to conclude that its neutral stance indicates equal probabilities of the policy rate being increased or decreased, or that the timing of action of rates is near.

Effective policies of the government in some areas notwithstanding, India’s macro has been, in large part, a warrant on international crude prices. Delivering the mandated 4% CPI inflation on a sustained basis as economic growth and corporate pricing power strengthen remains an ambitious goal. Frankly, a new tightening cycle has begun, in my opinion, but going by its unchanged neutral stance, the central bank isn’t sure.

Adjusting the monetary stance sooner with a gentle pace of rate increases is tactically better than being forced into stepped-up tightening following a delayed shift in the stance. The latter also increases the risk of overreaction.

Reality check: the MPC’s policy statements need better drafting. In April, it had expressed concerns about risks to inflation from state-level fiscal slippages. In June, it said that adherence to budgetary targets by the states appeared to be the case thus far and would ease upside risks to inflation. Shortly thereafter, the RBI in its annual assessment of state finances repeated its concern about fiscal slippages. Realistically, the aggregate state fiscal deficit will likely, yet again, exceed the budget target this year.

Rajeev Malik is a strategist at River Valley Asset Management, Singapore. These are his personal views.

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