Opinion | Why the RBI is likely to increase rates
It will look at the end-March 2019 CPI projection to calculate where policy rates need to be currently
Since 1 August, the day of the last Reserve Bank of India (RBI) policy meeting, the rupee has depreciated almost 6% against the dollar, and year to date, the currency pair is down more than 12%. A number of external factors—a strong dollar, high crude oil prices leading to a deterioration in balance of payments, depreciating Chinese renminbi and contagion risks from other emerging market countries—have combined to push the rupee to record low levels. Against this backdrop, we expect RBI to hike the policy repo rate by 25 basis points on 5 October and also change the monetary policy stance to hawkish from neutral. Beyond October, we expect RBI to hike again in December and April by 25 basis point each, thereby taking the terminal repo rate to 7.25%. We think RBI will stress on three related factors for justifying a rate hike in the October policy.
Real rates: With July and August consumer price index (CPI) inflation surprising to the downside on account of lower-than-anticipated food prices, average inflation for FY19 could be lower at around 4.5%, but end-March 2019 CPI will still possibly be around 4.8%, factoring in incremental risks from higher oil prices, rupee depreciation and procurement policy pertaining to summer crops. While CPI inflation may remain low till December, the six-month ahead trajectory will likely show inflation moving above 4.5% and real gross domestic product (GDP) growth showing signs of moving back to 7.5% trajectory in April-June 2019, after witnessing a base-effect led moderation in momentum through the next few quarters.
RBI, in our view, will look at the end-March 2019 CPI projection to calculate where policy rates need to be currently to maintain real rates around 2-2.25%, rather than calculating on the basis of the likely average CPI for this year. Calculating real rates on the basis of a CPI point estimate rather than an annual average will likely provide the justification to hike the policy rate by 25 basis points to 6.75% in the October monetary policy, with the objective of pushing real rates quickly toward 2% or higher, based on the end-March 2019 CPI forecast. This might imply close to 2.75% plus real rates in the immediate short term, based on the assumption that CPI will average about 4% in July-September 2018 and October-December 2018, but given the pressure on the rupee, we don’t think the central bank will mind keeping real rates above 2% at this stage.
Inflation expectations: Another justification that RBI may provide for hiking rates in the October policy, despite recent lower CPI inflation has to do with the inflation expectations outlook. Inflation expectations of households (one-year ahead basis) bottomed out in March 2018 and have started rising from April-June 2018. As per the June survey, inflation expectations of households increased further to 10.1%, from 9.9% in May and 8.6% in March, and may have remained elevated around the 10% mark, even in the current round of survey, results of which will be published post RBI’s monetary policy meeting on 5 October.
RBI could very well argue that though current CPI prints remain slightly softer, a rate hike is justified at this juncture to push inflation expectations down, especially in an environment of higher fuel prices and foreign exchange depreciation, which could result in inflation expectations remaining persistently elevated and undermining RBI’s inflation targeting objective. The central bank may even make it explicit that its objective is not only to achieve CPI inflation around 4% on a durable basis, but also to drive inflation expectations of households as low as possible toward the 4% CPI threshold, thus adding to the hawkish bias.
Containing current account deficit: The savings-investment identity implies that if a high level of investment rate needs to be maintained in the economy, without pushing up the current account deficit (foreign savings) to an unsustainable territory (as was the case in 2012), then domestic savings has to rise to fund bulk of the investment needs. With investment and the overall growth cycle showing signs of recovery, notwithstanding the sequential deceleration in momentum that is expected over the next few quarters, it is imperative for India to have policies geared toward raising the overall savings pool and particularly financial savings in the economy to fund the incremental investment needs.
If domestic savings, particularly financial savings, do not rise enough to fund the incremental higher investment needs in the economy, current account deficit will continue to increase to bridge the gap between domestic savings and investment. To avoid this, the government needs to stay on the path of fiscal consolidation to reduce overall dis-savings in the economy, which the authorities remain committed to and RBI will probably need to hike rates to incentivize greater mobilization of overall domestic savings, particularly financial savings.
Given the need to contain current account deficit below 3% of GDP, RBI may prefer not to wait and likely decide to deliver the next rate hike on 5 October itself, especially in an environment where inflation expectations of households have started to inch up, thereby leading to a further decline in real rates calculated in terms of repo rate minus one-year ahead inflation expectations of households.
Kaushik Das is India chief economist at Deutsche Bank.
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