A 25 bps rise in repo rate is less risky for RBI to balance trade-off between growth and inflation
The Reserve Bank of India (RBI) has now raised the repo rate for the second time on a trot by 25 basis points (bps). We had seen this coming —given the volatile and uncertain atmosphere—both on the domestic and the global front. From that point of view, it was probably preferable for RBI to hike the repo rate now than wait for later as the risks of a 50bps increase could have emerged if something were to go wrong—such as a sharp increase in the oil prices or even a sharper-than-expected depreciation of the Indian rupee on the back of trade war tensions.
A step-wise 25 bps increase in the repo rate was a less risky option for RBI in its attempt to balance the growth-inflation trade-off rather than a sharper increase in one go that could have had drastic implications for growth recovery. This policy decision was, however, not unanimous as the one in June was and one member voted for no change. It would thus be interesting to parse through the minutes to decipher the reasons for this member to have opted for no change in the repo rate. The inflation backdrop in the run-up to this policy was not too conducive. Both the headline and the core CPI (consumer price index) inflation had moved up in June compared with May. Further, the “compositional shift" to inflation alluded at the June policy continued, whereby food inflation remained muted due to lower-than usual seasonal uptick in prices of fruits and vegetables in summer months. RBI remains concerned of the rising household inflation expectations while input cost of manufacturing firms, companies in the service sector as also the farm sector has reported a rise.
Given a continued assessment from the MPC that domestic economic activity has sustained its momentum and the output gap has virtually closed, the inflation risk emanating from the domestic demand conditions (along with the fact that the MSP increase as also the farm loan waivers are likely to provide a demand push in the rural sector) are too large to be ignored.
Having indicated the above, RBI remained cognizant of the various uncertainties to inflation in the months ahead. And this is why the continued “neutral" stance, despite hiking the repo rate in two consecutive policies. The neutral stance no doubt would provide the necessary flexibility for future actions, dependent on data flows and not tie the hands of the RBI into one single direction. While crude oil continues to remain volatile, an intensification of protectionist trade policies could impact long-term global growth prospects and pull down inflation levels through an erosion in crude and commodity prices. Global financial market volatility—implied in the direction of the rupee—is also likely to impact inflation trends. Further uncertainty remains with the implementation strategy of the MSP and the extent to which headline retail inflation could be affected.
What next from RBI? Post policy, 10-year bond yields increased to 7.85% but cooled off subsequently to close at 7.70%, with the market pricing in no further rate change from the RBI. This is possibly on the back of the RBI retaining its “neutral" stance—that continues to signal that the rate hikes might remain shallow. However, we note that the outlook for headline retail inflation as announced for H2FY19 is 4.8%, higher than its medium-term goal of 4%. Worse, RBI expects headline inflation to rise to 5% in Q1FY20.
Importantly, the household inflation expectations model for June continues to show a rise for both the three-month and the one-year ahead horizons, compared with the last round by 20bps in each case. Remember that the May expectations had shown an increase of 90bps and 130bps respectively for the three-month and one-year ahead periods. Given this, we think that in order for the RBI to ensure credibility of policy-making in achieving the medium term target of 4% headline CPI, there is one more increase of 25bps in the repo rate coming up at its October policy.
Indranil Pan is chief economist at IDFC Bank.
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