After the RBI had raised the repo rate for the second time in this cycle in August, the general market sentiments veered towards no further tightening by the RBI, especially as the monetary policy stance stayed “neutral”. A significant lot has transpired domestically as also internationally from 01 August to today.
First, between August and now, the Headline CPI inflation has definitely come down, registering only 3.7% as per the last reading. In a normal scenario, the RBI should have been sitting comfortably — having pulled down the Headline number below the 4 per cent handle. The core inflation also has dropped. However, from August to now, Indian crude oil basket has moved up by around 12 per cent, while INR depreciated by 6 per cent. Even as the metal space has increase by just 1.4 per cent in this period, the overall input cost pressure on the manufacturers have increased. And in an atmosphere where the output gap — as indicated by the RBI — has almost closed, inflation in the future has to go higher. Our own calculations indicate that there is a risk for Headline inflation to be closer to 5 per cent by end March 2018. To prevent denting the credibility of the MPC, further rate hikes are warranted.
There are other concerns too. The overall evolving atmosphere globally is for a tighter monetary policy. US Fed is now signalling five more increases from now on. ECB has also indicated some confidence towards stoppage of its QE by December 2018. On the other hand, Emerging Market Economies had also been tightening its monetary policy. Along with the latest round of increase, both Indonesia and Philippines has now increased their policy rate respectively by 150bps. On a comparative basis, India has just increased by 50bps till date. Understandably, while there may not be a need for RBI to follow step-for-step with monetary policy changes elsewhere, but falling too significantly behind the others could be risky in the current atmosphere.
India now finds itself in a situation of a rising CAD while the means of funding the same are drying out. A higher CAD is a reflection of the fact that domestic investments have been higher than domestic savings and a rise in the interest rates could therefore be helpful in correcting for this dis-balance. Allowing the CAD to sustain at a higher level, in an atmosphere where funding the same is becoming challenging could be a harbinger for financial sector instability and needs to be avoided urgently. This should also be a consideration for the RBI for tightening monetary policy further and anchor the financial stability of the economy, rather than only looking at CPI targeting.
Effectively, we think that the RBI will raise the repo rate by a further 25bps in October, and could well follow it up with another 25bps in December.
Indranil Pan is chief economist, IDFC Bank. The author’s views are personal