Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Opinion | The case for another interest rate hike

A comparatively conservative policy stance will serve India better at this stage

The macroeconomic outlook has changed considerably since the last meeting of the monetary policy committee (MPC) of the Reserve Bank of India (RBI), and so have expectations in financial markets. The majority of analysts now expect the rate-setting committee to raise policy rates later this week, largely due to developments on the external front. This newspaper also believes that there are reasons to raise policy rates at this stage.

Though the MPC is driven by the inflation targeting mandate, renewed weakness in the rupee will affect inflation and inflationary expectations. Further, crude prices have risen over 12% since the last meeting and are expected to remain elevated in the coming months. New forecasts suggest that crude prices could actually rise above $100 per barrel in the foreseeable future. The Organization of the Petroleum Exporting Countries is unwilling to increase production and sanctions on Iran is affecting supplies.

Apart from pushing inflation, higher crude prices would further increase the current account deficit (CAD) and put more pressure on the currency. Financing the CAD would not be easy in the current global environment. Though the US Federal Reserve is raising rates along expected lines, continued tightening will affect capital flows to emerging market economies. The US central bank is expected to raise interest rates once more this year, followed by three rate hikes next year. Foreign investors have sold Indian assets worth over $11 billion so far this year.

The Union government has taken several steps in recent weeks to attract capital flows and reduce “non-essential" imports. However, these measures are unlikely to yield the desired results. On the contrary, encouraging short-term debt inflows and arbitrarily raising import duty can do more harm than good in the medium term. It is important to highlight that there are no easy short-term solutions to reduce pressure on the external account. One of the biggest problems is that India’s exports have remained sluggish in recent years. The government should focus on removing impediments for reviving exports. The depreciation in rupee should help exporters here—but only to an extent given that the data shows that this relationship is somewhat weak in India. Further, the newly constituted high-level advisory group would do well to suggest exact policy measures that will help boost exports.

Higher crude prices will also increase fiscal risks. The government has done well to resist the pressure to reduce taxes on fuel products. However, in an election year, the pressure will only increase with rising retail prices. There will be significant political resistance if the price of petrol goes, say, into three digits. The central bank should be prepared for possible fiscal slippage. Higher crude prices have complicated India’s macroeconomic management. Also, it comes at a time of tightening global financial conditions.

Although the headline inflation is currently under the central bank’s target, the MPC’s decision will be based on its future trajectory. The inflation forecast is likely to go up on the back of higher crude prices and a weaker currency. A rate hike at this stage would be a prudent response and give confidence to financial markets that the central bank is willing to sacrifice some growth to maintain price and macro stability. In fact, the increase in CAD and sustained higher core inflation suggest that there is a case for some moderation in demand and, in an election year, monetary policy will have to do a balancing act. This will also help ease pressure on the currency.

Therefore, a pause at this stage could confuse the market and may lead to greater volatility, particularly in the currency market. Yields on 10-year government bonds have gone up by over 30 basis points since the last policy review. Also, if the MPC decides not to act now, it will have to wait till December to make the next policy move. This could lead to greater uncertainty in the market. Apart from the policy action, financial markets will also closely watch the tone of the policy statement. It will be interesting to see if the MPC throws more light on the inflationary impact of currency movement.

As for the view that rates should not be increased for now due to tight liquidity and risk aversion in parts of the financial system, these issues can be dealt with separately and the central bank is working to improve the liquidity situation.

Higher crude prices and the tightening of financial conditions in global markets are the biggest risks to India’s macroeconomic stability at the moment. It is important that policy in India adjusts to changing economic realities and financial markets don’t lose confidence. Thus, a comparatively conservative policy stance will serve India better at this stage.

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