BackOpinion | The MPC faces the risk of losing the plot
The MPC's neglect of the factors affecting the rupee's health has come back to haunt it
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This week’s monetary policy committee’s (MPC) meeting takes place in circumstances that are drastically different from those that dictated the tone and outcomes of its recent meetings. Headline consumer price index (CPI) inflation has eased significantly for two consecutive months, but the rupee’s palpitations and tight domestic liquidity complicate the picture. With Brent oil prices rising up to $85 per barrel, India’s growth strengthening, global liquidity tightening, and core inflation already uncomfortably high this early in the recovery phase, the MPC should hike the repo rate again.
A shift in the MPC’s monetary stance to tightening from neutral is overdue. With two rate hikes of 25 basis points (bps) each already in the bag, and another two to four same-sized increases likely in the pipeline, a shift in the monetary stance is warranted.
The upcoming policy meeting will also be accompanied by the Reserve Bank of India’s (RBI) biannual monetary policy report. The inflation forecast will be revised higher because of rising crude oil prices and the outsized rupee depreciation. One should nurture healthy scepticism about the MPC’s delivering on its medium-term CPI inflation target of 4% on a sustained basis. The inflation risk in India over the next couple of years continues to be underappreciated, in my view.
The MPC members would need to interpret different forces—at time opposing—to map their policy response function. Globally, international oil prices have risen meaningfully since the last review despite signs of global growth shedding some momentum. There continues to be uncertainty over the magnitude of the fallout from the still-evolving US-China trade friction, though some countries, especially in South-east Asia, would potentially benefit from the recalibration of supply chains as businesses cut their exposure to production in China. Finally, higher tariffs threaten to contribute to global inflationary pressures, partially reversing the disinflationary forces that had been unleashed by China’s emergence as the world’s factory.
It is also worth bearing in mind that the current up-move in oil prices is vastly different from the surge in 2002-08. This is because it is playing out in the background of US dollar appreciation and tightening global liquidity. These factors accentuate the fallout from higher crude oil prices, in contrast to the ballooning global liquidity in 2002-08 that pushed the rupee to appreciate despite a surge in international crude oil prices.
Domestically, CPI inflation eased for the second straight month in August, coming in at 3.7% compared with 4.2% in July. Lower food inflation was the main driver. Core inflation, which excludes food and energy, also moderated, but remained uncomfortably high at 5.9% in August (July: 6.3%). The below-trend pace of food inflation is unlikely to be sustained. Indeed, its reversion to a trend pace would push up headline inflation if core inflation remains uncomfortably high.
The upcoming meeting will perhaps be the first since the MPC’s birth in 2016 in which members would have to discuss the importance of macro-prudential stability while deciding on policy interest rates. There is no reason why the MPC, following a flexible inflation targeting framework, cannot incorporate factors, including exchange rate dynamics, that threaten financial stability as it brainstorms the path of inflation and policy interest rates.
The broad exclusion of the rupee, or the very limited role it plays, in the MPC’s thought process is perhaps best indicated by the following: Across the minutes of the policy meetings in the last one year, the six MPC members between them mentioned the word “rupee" only once in their stated comments. The rupee isn’t freely floating to be left on its own, and it is risky for emerging market MPCs to only think about the exchange rate as an afterthought via its impact on the inflation outlook. Indeed, there is merit in incorporating the goal of exchange rate stability to decide policy rates, thereby preventing a hit to confidence and the inflation outlook from outsized and destabilizing currency depreciation.
The rupee has weakened 12% year-to-date against the US dollar and ranks as the worst-performing emerging Asian currency. It was a mishap waiting to happen, especially in the context of last year’s nominal appreciation— thanks to RBI’s blessing—that contributed to its overvaluation in real effective exchange rate (REER) terms. Policymakers also ignored the widening of the current account deficit (CAD). More troubling is the fire-fighting measures announced so far to pacify the rupee; these hint that policymakers are relying on Band-Aids instead of addressing the structural fault lines that contributed to the rupee’s falling out of bed yet again. As India’s experience shows, these patches don’t work in fixing the underlying problem.
Indian policymakers have elevated (8% plus) growth expectation but achieving that goal becomes a risky strategy via an unpalatably wide CAD and/or higher inflation. Looking ahead, even a stable CAD shortfall of 2.5% of gross domestic product (GDP) will imply financing requirement of nearly $100 billion in three years. India appears ill prepared for that challenge in the backdrop of tightening global liquidity. Frankly, ensuring greater macro stability via slightly slower (say, 7-7.5%) but more sustainable growth should be preferred over 8% plus growth that is unsustainable. The MPC shouldn’t ignore that distinction.
Postscript: RBI should replace the Centre’s fiscal deficit with the consolidated (Centre plus states) fiscal deficit in the table of baseline assumptions in the biannual monetary policy report. What matters for macro management is the combined fiscal position of centre and states. Just because there is no official forecast for it is no reason to avoid publishing its assumption especially since it must also be used in internal macro modelling.
Rajeev Malik is a strategist at River Valley Asset Management, Singapore. These are his personal views.
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