With the worsening of the Consumer Price Index (CPI)-based inflation outlook since the April policy meeting, we think a rate hike and a shift in the policy stance to ‘withdrawal of accommodation’ from ‘neutral’ are highly likely in the June Monetary Policy Committee (MPC) meeting, even as the growth recovery remains nascent. In total, we expect 50 basis points (bps) hike in 2018, with the first hike being delivered in June itself.
Indeed a hike in 2018 has become a consensus call, a sharp contrast to the April MPC meeting. With an upward surprise in April CPI and core-core inflation at 6.2% concerns on inflation have risen. Core-core inflation is headline CPI, excluding food, fuel and transport and communication.
A quick paced move in crude oil prices to a four-year high in a short span of two months along with a weaker Indian rupee have further worsened the inflation outlook. India is highly sensitive to oil prices—every $10 per barrel increase in crude oil prices can add 20-40bps to headline inflation, widen fiscal deficit by 0.1-0.4% of gross domestic product (GDP) and current account deficit (CAD) by 0.4% of GDP. We expect FY19 CPI at 4.80%, (3.6% in FY18) much above the MPC’s comfort threshold of 4% assuming oil prices average at $71 per barrel. The likelihood of wider than budgeted fiscal deficit for central government is also likely to concern MPC.
The only debate is around the timing of the first hike. Most economists expect a hike in August as clarity on monsoon and minimum support prices (MSP) announcement will be available by then. We agree that these will definitely help in better decision making. However, as some of the risks to inflation (like higher oil prices) as previously highlighted by MPC have already materialised, a rate action next week is warranted. The case is also strong as risks if any to FY19 CPI are on the upside.
All inflation projections (including MPC’s) currently assumes a normal monsoon and have not yet factored in for any sharp rise in MSP. Hence negative surprises on these have the potential to add further to inflation pressures. According to our estimate, a sharp increase in MSP has the potential to add 35-40bps to headline CPI. Waiting till August is thus unlikely to give cues on lower price pressures unless one holds a sanguine view of lower crude oil prices. Hawkish minutes of the April policy meeting have also prepared the market for a hike. Two votes in favour of a hike are expected in June policy meeting. In our view, the Reserve Bank of India (RBI) governor’s vote will be the deciding factor. Thus a rate action next week will be a prudent move and can reaffirm MPC’s inflation fighting credentials, which is important in today’s global environment. We expect MPC to remain vigilant on further risks to CPI in its monetary policy statement leaving the room open for another rate action in the future policy meeting.
Having advocated the case for a 50bps hike starting next week, we believe the hiking cycle will be shallow. Real rates are still elevated, at 150bps. Additionally, the MPC did not reduce policy rates aggressively in response to downside CPI surprises over the past two years. This suggests that the upturn in the rate cycle will be limited unless inflationary pressures turn out to be significantly stronger than current expectations. Will bond yields harden further on a hike? Our sense is no. The market is already pricing in more than two hikes over the next 12 months. As long as the MPC underpins its hawkishness based on incoming data, markets are unlikely to react negatively. Clarity on RBI’s liquidity stance will be watched carefully especially as a change in monetary policy stance is expected in the June policy meeting.
Anubhuti Sahay is head of South Asia Economic Research, Standard Chartered Bank.