Economy must adjust to recent rate hikes, eye on inflation needed: RBI MPC

File Photo: Reserve Bank of India
The economy faces several uncertainties and upside risks from the continuous rise in oil prices, volatility in emerging economies’ financial markets, uncertainty surrounding the impact of increase in Kharif crop minimum support prices and the risk of fiscal slippage by central or state government(s). This was revealed in the minutes of the Reserve Bank of India’s (RBI) October monetary policy meeting.

While all members of the Monetary Policy Committee (MPC) voted in favour of a change in the RBI’s stance from “neutral” to “calibrated tightening”, only one member of the committee, Dr Chetan Ghate, voted for a 25 bps increase in the repo rate.

In October, the MPC during its meeting shifted its stance on inflation targeting from “neutral” to “calibrated tightening” and kept the policy repo rate unchanged at 6.50 per cent.

“Calibrated tightening” means that for the foreseeable future the RBI would not announce a cut in the policy repo rate but at the same they are not obligated to increase the rate during the coming policy meetings.

According to Viral Acharya, deputy governor of the RBI, “Growth has been reasonably buoyant as evidenced by the real economic activity indicators for both the rural economy and the urban counterpart. Our estimates of the output gap suggest it has virtually closed as per the traditional measures; my preferred finance-neutral output gap measure has in fact turned positive due to asset price growth and especially non-food credit growth that is now in excess of the nominal GDP growth rate.”

He says that it is important, given the RBI’s mandate of flexible inflation-targetting, that the MPC moves forward carefully taking action at appropriate moments, allowing the economy to adjust to the two back-to-back rate hikes “while being vigilant of any emerging inflationary pressures.”

Going forward, Consumer Price Index (CPI) inflation is projected at 3.7 per cent in Q2 of FY2019, 3.8 to 4.5 per cent in H2 of FY2019 and 4.8 per cent in Q1 of FY2020, excluding the impact of House Rent Allowance (HRA) implementation.

Gross Domestic Product (GDP) growth is projected at 7.4 per cent for FY2019, while growth in Q1 of FY2020 was revised lower to 7.4 per cent as against 7.5 per cent, which the MPC had projected in its August meeting.

Further, rising oil prices and tightening of financial conditions will impact investment demand, while consumption will be sustained, noted RBI Governor Urjit Patel.

“A further increase in inflation expectations of households at three-month horizon, when combined with rising input costs, may impact price and wage setting behaviour, though it is comforting that one-year ahead inflation expectations have moderated,” Patel said.

The RBI’s survey of household expectations found that there is a 50 bps rise in household expectation of rising in inflation in the next three months, while there was a 30 bps reduction in households’ expectation of inflation rising over the next one-year.

Moderate inflation in the last two months has led to a lower projected inflation path, he said.

The July to September round of the RBI’s Industrial Outlook Survey found that manufacturers are expecting a rise in the cost of raw material as input prices are rising, which would lead to higher selling prices. 

Growth in Indian exports “remains in the doldrums, indicating an unfavourable Indian export growth outlook,” says Dr Pami Dua.

Dua voted in favour of keeping the policy repo rate unchanged stating that, “While inflation has softened, upside risks to inflation remain, along with some downside risks to output growth. Due to the transmission lags, the effects of these may take time to play out. It is therefore best to pause and wait and watch while maintaining a vigil on inflation.”

Dr Ravindra H Dholakia voted not to hike the policy repo rate by another 25 bps but raised an important point regarding the sancticity of the RBI’s estimations of inflation.

“The effective inflation forecasts for the short to medium term are much less than what RBI considers because of the lack of precise information,” he says.

This is due to the imperfect estimation of the impact of the HRA revisions as proposed by the 7th Central Pay Commission for central and state public sector enterprises, autonomous bodies, universities and other organizations that provide housing to their employees.

“Since such households would form a significant proportion of the CSO sample households (almost similar to the one for the central government employees) for estimating housing CPI, there is a considerable overestimation of the effective inflation rate for the headline and more so for the CPI-ex-food and fuel,” he said.

RBI Executive Director, Michael Debabrata Patra voted to not increase the policy repo rate.

The only member of the MPC to vote for a rate hike of 25 bps is Dr Chetan Ghate, who said, “What worries me on the pickup in growth is the dismal consumer confidence numbers, with consumer confidence in Q2 FY 18-19 worsening. Ideally, in a growing economy, the durability of growth is better sustained if it is supported by growing consumer confidence. Notwithstanding this, I continue to remain sanguine about current and medium term growth prospects as in the last policy,” according to the minutes of RBI’s MPC meeting held between 03 and 05 October.

The MPC is facing a dilemma when making decisions, says Ghate, on the one hand if the RBI moves too quickly in terms of raising the repo rate it can shorten growth prospects of the economy, while on the other if the central bank hikes rates too slowly there is a risk of over-heating in an economy with a nearly closed output gap.

“If there is substantial deviation of inflationary expectations in relation to the target, by failing to react with the policy interest rate, we will lose credibility and reduce our capacity to influence expectations,” he stated.