After months of maintaining the status quo, the monetary policy committee
could reach a turning point at its June meeting. Recent developments — both domestic and global — suggest three reasons to consider a shift from ‘neutral’ to a ‘withdrawal of accommodation’.
First, the economy is experiencing a strong cyclical recovery, having dusted off the twin shocks of demonetisation and implementation of the goods and services tax. Both the engines — private consumption
and fixed investment —are currently robust. The strength in import volumes is also testament to solid domestic demand.
Second, consistent with increased domestic demand, core inflation has risen. The jump in services inflation in April looks particularly alarming and possibly reflects a release of pent up inflation pressure at the start of the new financial year in a rapidly formalising economy. There are various ways to measure core and some of the standard year-on-year core measures are distorted due to base effects or because they incorporate the statistical house rent allowance impact or higher petrol and diesel prices.
Close yet far: While growth is picking up cyclically, it may not sustain. Even without a change in the policy rate, market interest rates (and bank lending rates) have moved higher
Given these distortions, we focus on the ‘super core’ or consumer price index (CPI) inflation excluding food and beverages, fuel, housing rent, petrol and diesel prices. On a seasonally adjusted basis, ‘super core’ inflation rose by 0.63 per cent month-on-month (m-o-m) in April versus an average rise of 0.41 per cent m-o-m during October-March. Even if one ignores the April jump, underlying inflation has been running at an annualised rate closer to 5 per cent in the last six months.
Subdued food inflation has partly offset higher-than-expected core. Food (excluding vegetable) prices have risen by only 0.55 per cent between January and April this year, which is significantly below the average rise of 2 per cent during the same period in 2014-16, partly due to supply glut and also due to lower input costs. But the question is whether low food prices will sustain.
While the expectation of a normal monsoon is good news for food inflation, the impending decision to raise minimum support prices (MSP) and efforts to make MSPs an effective floor for all crops through a fiscal transfer mechanism are upside risks, especially if it entails physical procurement by government agencies. Higher MSPs alone could add around 50bp to headline CPI inflation, on our estimates.
More recently, higher oil prices and a weaker Indian rupee have emerged as additional risks. Since the April policy meeting, Brent oil prices have risen by about $8-9/barrel, while the rupee has depreciated by 3.5-4 per cent against the US dollar. The two together can add about 40bp to headline inflation.
Third, recent global developments have increased emerging market risk premia. The combination of a stronger US dollar and higher US yields have resulted in portfolio outflows and caused balance of payment strain on a number of economies. Countries such as Argentina, Turkey and Indonesia have responded by hiking interest rates to preserve financial stability. The double whammy of higher oil prices and portfolio outflows has hit India too, and we estimate the balance of payment has been in deficit since mid-April. As global quantitative easing gives way to quantitative tightening, emerging markets have to be prepared for lower capital inflows, higher volatility and higher risk premia. Macro stability considerations should remain at the fore, especially for current account deficit countries like India.
Every coin has two sides and there are arguments against tightening. First, the mandate of the monetary policy committee
is headline inflation. Excluding the statistical house rent allowance impact, CPI inflation is likely to average around 4.5 per cent in 2018-19 relative to a repo rate at 6 per cent, which suggests the real policy rate cushion is still sufficient.
Second, while growth is picking up cyclically, it may not sustain. Even without a change in the policy rate, market interest rates (and bank lending rates) have moved higher. This tightening of financial conditions — along with the adverse terms-of-trade shock from higher oil prices — will eventually hurt growth. Moreover, the new investment pipeline remains lacklustre; bank balance sheets are fragile; and the process of bad asset resolution will take at least another year. Therefore, while growth will likely be strong in the next few quarters, it may fizzle out later this year. Monetary policy has to be forward looking.
Of course, the pertinent question to ask here is that if balance sheets are as stressed as they are, then why is core inflation so strong? We believe this possibly suggests that India’s potential output has fallen over the years due to inadequate investments.
To be sure, the arguments on both sides of the hike or no hike debate are “fair”. Left to weak domestic balance sheet considerations alone, there is a case for monetary policy to wait-and-see, as sharply higher real interest rates could delay balance sheet improvement.
However, changing global dynamics (higher oil prices, rising risk premium) also mean that India does not have the luxury of time anymore. In conjunction with higher-than-expected core inflation and the need to reinforce credibility in the early stages of the flexible inflation targeting regime, we believe the balance is tilted in favour of a reversal, including the cut delivered last August. The only debate now is by how much and when.
Given India’s starting position of higher real interest rates, weak bank balance sheets and already tighter financial conditions, we believe the economy does not need significant tightening. However, signalling is important. Given the delayed impact of monetary policy and the current investor focus on twin deficit economies, the signal should be given sooner rather than later.
The author is chief India economist at Nomura