Inflation risks amid closing of output gap prompt back-to-back rate hikes
The central bank’s retention of the neutral stance helped to cool govt bond yields
With mixed cues regarding the balance of inflation-fiscal-growth risks for the Indian economy, the market was rather divided on whether the monetary policy committee (MPC) would deliver a back-to-back hike in the August 2018 policy.
Ultimately, the concerns related to the persistence of various inflationary risks prevailed, with the Committee describing the output gap as having virtually closed. The MPC voted 5:1 to hike the policy repo rate by 25 bps to 6.5% in the third policy review for the year, in line with our expectations. As anticipated, the Committee retained the stance of monetary policy at neutral instead of revising it to withdrawal of accommodation, which suggests that the future rate action would remain data-dependent.
The Committee highlighted a number of inflation risks, including volatile and elevated crude oil and other commodity prices, volatility in global financial markets, a further rise in the inflationary expectations of domestic households, the unfavourable distribution of the monsoon in the first two months, the potential impact of revised minimum support prices (MSPs) on the prices of kharif crops as well as evolving fiscal risks. Based on such factors, the MPC fine-tuned its inflation projections to 4.6% for Q2 FY2019 and 4.8% for H2 FY2019, while placing its forecast at 5% for Q1 FY2020.
With a pickup in industrial growth, healthy capacity utilization, buoyant business sentiment and favourable service sector activity, the MPC concluded that the domestic economic activity remains robust.
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Based on the progress of the monsoon and the revision in MSPs of kharif crops, rural demand is expected to remain healthy. The Committee remarked that investment activity remains firm, despite some recent tightening of financing conditions, and that rising FDI flows and buoyant domestic capital market conditions augur well for the outlook for investment activity. Nevertheless, the MPC highlighted some growth risks such as the impact of escalating trade tensions on Indian exports as well as the concerns related to the effect of geopolitical tensions and higher crude oil prices on global growth.
Overall, the MPC retained its GDP growth projection for FY2019 at 7.4%, building in an expected easing from 7.5-7.6% in H1 FY2019 to 7.3-7.4% in H2 FY2019, with risks evenly balanced, while placing its GDP growth forecast for Q1 FY2020 at a higher 7.5%.
The retention of the neutral stance helped to cool government security (G-sec) yields after the policy announcement, as the rate hike itself was already priced in.
During the remainder of the ongoing quarter, we expect the 10-year G-sec yield to trade in a range of 7.65-8%.
On the one hand, the emergence of clarity on the impact of various inflationary concerns, as well as the extent of fiscal risks and the central and state government borrowing programme for H2 FY2019, may emerge as triggers for a rise in bond yields.
On the other hand, the announcements of additional open market operations by the RBI could help cap G-sec yields.
Depending on the impact of various risks on the evolving inflation outlook, a final rate hike of 25 bps may emerge towards the end of FY2019, particularly given the MPC’s inflation projection for Q1 FY2020 is presently placed at 5%, well above the medium term target of 4%.
However, there may not be enough clarity by the October 2018 policy, on the impact of specific inflation risks such as the revised MSPs on the prices of kharif crops (with the harvest and procurement to take place in October-November 2018), to support a rate hike at that meeting.
Aditi Nayar is principal economist at Icra.
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