Opinion | The RBI’s monetary policy dilemma
The wholesale price index inflation numbers point toward continued input cost pressures
The upcoming monetary policy announcement of the Reserve Bank of India (RBI) is beset by multiple complications. But, unlike before, the central bank is closely tied to the objective of price stability, implying that policy decisions are strongly guided by the prevailing inflation. Hence, with the headline inflation declining to 3.7% for August due to volatile primary food inflation, the RBI will find it difficult to justify a rate hike. But this will be a temporary respite.
In addition to just the inflationary considerations, the recent 13% weakening in the Indian rupee against the US dollar has been significantly sharp and has become a critical consideration of monetary policy management. The rising prospects of higher Fed rates (fair value estimated above 3.5%), amid the backdrop of a strong US economy, have important implications for India. The decline in India’s forex reserves in the context of the emergence of balance of payment deficit underpins the relevance of the RBI matching rate actions with global rates, notwithstanding the prevailing headline inflation.
Further, despite the recent decline in headline inflation, the market interest rates have already hardened. For instance, the benchmark 10-year government security (G-sec) yield has already hardened beyond 8%. Lending and deposit rates of banks have also hardened along with corporate bond yields.
So, how do we see the RBI responding to these cross-currents? Since monetary policy targets the headline consumer price index (CPI) inflation, it is most likely that the committee members will opt for a status quo in recommendation. However, with the core inflation remaining at a high of close to 6%, the majority of the arguments are likely to be fairly hawkish, encompassing other considerations such as currency value, global rates, and domestic trends like the emerging deficiency in liquidity and hardening market yields. We are of the view that beyond the near-term softening, the inflation trajectory will eventually converge closer to the core inflation, thereby creating room for two more rate hikes before the end of FY19. Based on recent data, we now see a scope for raising our fair value estimate for 10-year government bond yield from 8.4%.
Beyond the recent softening, inflation headwinds have heightened: Retail inflation eased below 4% in August, which has primarily to do with the volatility in food inflation; excluding the volatile vegetables component, the CPI is still hovering around 5%. Core inflation remained elevated at 5.9% in August. With the depreciation in currency, inflation from rising input prices, and the improvement in demand conditions, the pressure on core inflation is likely to intensify.
The wholesale price index inflation numbers point toward continued input cost pressures. The 30% hardening in global crude prices along with a 13% depreciation in the rupee is creating considerable pipeline pressure in the form of transportation and packaging costs, coupled with a rise in raw material costs. The re-emergence of margin pressure on the manufacturing sector should be sufficient to push up both the wholesale price index (WPI) and CPI headline inflation going forward. In addition, increasing global trade restrictions and tariff hikes can impart further inflationary pressure.
Deficit in foreign exchange buffer may prompt greater rupee flexibility: The rising volatility in imports and the narrowing interest rate differential (India-US) have resulted in a rise in estimated optimal foreign exchange reserves to $436 billion as per our buffer stock model, thereby creating a shortfall of $37 billion compared with the actual $399 billion. This, along with the criticism that the RBI is facing for adopting an inflexible currency management approach, is likely to keep a check on RBI’s active foreign exchange interventions, and thus building up the imperative for higher short-term rates to attract or retain external capital. We see the possibility of the rupee weakening to 75 levels against the US dollar.
The tightening in liquidity conditions to further intensify: Liquidity position, according to liquidity adjustment facility data in the last few days, has been increasingly tightening. All monetary parameters, including growth of currency in circulation of 22.7% year-on-year and reserve money growth of 19.3%, are moving in line with our estimates. Non-food credit growth at 14.3% year-on-year in August is near to our projection of 16% for FY19. However, foreign-currency assets (FCA) have declined by $27 billion. These circumstances indicate tight liquidity conditions, which call for higher durable liquidity injection by the RBI.
The tightening in global liquidity may lead to a lower contribution from FCA to base money expansion, increasing the burden on the RBI to inject liquidity by way of monetizing G-secs through open market operations (OMO) purchases and other money market instruments. Our earlier estimate of OMO purchases of ₹2 trillion in FY19 was based on the assumption of a modest 5% rise in FCA. But given the decline thus far, the risk is now tilted to the higher side. Year to date, the RBI’s incremental credit to the government has been ₹2.12 trillion, in which the central bank’s OMO purchases of G-secs have been just ₹300 billion. In sum, the anticipated status quo policy stance of the RBI is pivoted on the immediacy of soft near-term inflation numbers, but the central part of our argument is in favour of an increasingly hawkish stance as we expect the respite to be fairly ephemeral.
Dhananjay Sinha is head of research, economist and strategist at Emkay Global Financial Services.