The monetary policy committee (MPC) of the Reserve Bank of India (RBI) surprised the market by keeping policy rates unchanged. Most financial market analysts expected the rate-setting committee to raise policy rates by 25 basis points. This newspaper had also argued in favour of a rate hike. However, the committee changed the policy stance from neutral to “calibrated tightening". This basically means that the possibility of a rate cut in the current cycle is now off the table. The change in the policy stance is in the right direction, but the decision to not raise rates is puzzling.
It shows that there is a considerable difference in the way the MPC and financial markets are interpreting the evolving economic situation, which was also reflected in the post-policy press conference. The decision can perhaps be explained by the fact that inflation projections have been revised lower and the MPC believes that the last two hikes are sufficient to keep inflation close to the target.
However, many analysts were of the view that rising crude and the falling rupee deserved a rate response. The tightening of global financial conditions and rising interest rates in the US will make financing of the current account deficit (CAD) difficult. This will put downward pressure on the rupee and raise inflation risks. Though the government is said to be working on ways to reduce the CAD, the steps taken thus far are unlikely to have a meaningful impact.
Furthermore, comments in the press conference suggested that the MPC is not particularly worried about the fall in the rupee. It was reiterated that the RBI’s policy is to manage undue volatility in currency and not target any level. This is well accepted and the market was not expecting the central bank to start targeting a particular level in the currency market.
However, in the present situation when volatility is likely to remain elevated, policy tightening would have helped. It would have sent a signal to the market that the central bank is willing to compress aggregate demand to deal with CAD and inflationary risks emanating from the weakening of the currency. This would have reduced the need to use foreign exchange reserves to contain volatility. The move would have also been consistent with the legislated mandate of inflation-targeting and the wider objective of protecting financial stability.
However, by not raising rates, the MPC has left the currency market to do the macro adjustment. This could be risky. It is likely that the pressure on the rupee will increase. Though there is a case for gradual depreciation, the risk now is that the currency might overshoot significantly on the downside and affect economic activity, along with raising inflationary expectations and financial stability risks. Such an outcome can affect the credibility of the central bank. It can also have a bearing on the central bank’s ability to anchor inflationary expectations. In the given economic situation, a more conservative approach would not have hurt. In fact, it would have helped in anchoring inflationary expectations. It is likely that RBI is currently underestimating inflationary risks.
Interestingly, a new analytical chapter from the October edition of the World Economic Outlook, released by the International Monetary Fund last week, is focused on monetary policy challenges in emerging market economies and is worth highlighting here. It notes: “…improvements in the extent of anchoring of inflation expectations can significantly improve economic resilience to adverse external shocks in emerging markets. Anchoring reduces inflation persistence and limits the pass-through of currency depreciations to domestic prices, allowing monetary policy to focus more on smoothing fluctuations in output."
Though the inflation projection for the rest of the financial year has been lowered, the MPC has also highlighted a number of risks, such as higher crude and support price for agricultural products, which can result in higher inflation. The risk of fiscal slippage has increased. Last week the Union government decided to reduce excise duty on petrol and diesel. Several state governments have also cut value-added tax.
With the announcement of the assembly election schedule, the country has formally entered into a long spell of elections and the government will be under pressure to cut taxes, as crude prices are widely expected to go up further. New forecasts show that crude can cross the $100 per barrel mark in the coming months.
Overall, as things stand today, it can be argued that the MPC’s decision will lead to a fair amount of uncertainty in financial markets. This policy pause is likely to be short-lived.
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