Why the battle for macro stability is not yet over

Illustration: Jayachandran/Mint

The monetary policy committee of the Reserve Bank of India, which meets this week to finalize its next move, is likely to hold interest rates at current levels, while sounding hawkish in its analysis of the year ahead. Even the Union finance ministry seems to have accepted the fact that there is now no space for monetary easing. There is even a slim chance of a rate hike.

Most economists expect average inflation in the next fiscal year to be at the higher end of the inflation target range that the government has given the central bank. This is a far cry from the situation in June 2017, when headline consumer inflation was below the lower end of the inflation target, and the Indian central bank came under intense fire for being unnecessarily hawkish. For the record, inflation has more than trebled over the past seven months—or by 3.67 percentage points between June and December. The decision to switch from an accommodative to a neutral stance a year ago now seems justified, given that monetary policy looks at future rather than past inflation.

The bond market has already expressed its inflation concerns. The yield curve is at its steepest in many years. The widening gap between the call money rate and the yield on 10-year bonds is a sign of heightened inflation expectations. This is perhaps one of the first instances when the bond market could be leading monetary policy rather than following it, an important structural change in an economy that still has financial repression.

There are three main concerns clouding the inflation outlook. First, global oil prices are now close to $70 a barrel. A rise in global oil prices usually feeds domestic inflation. Second, there is now greater uncertainty about the trajectory of food prices after the announcement made by finance minister Arun Jaitley in the budget that farmers would get 1.5 times their costs. It is unclear what formula will be applied to calculate costs, as well as how higher support prices will be funded given fiscal constraints. Third, the higher import tariffs on a range of consumer goods could increase domestic prices.

The prospect of higher inflation in 2018 should be seen against the larger global backdrop. US bond yields have already spiked on concerns about higher inflation as the labour market tightens. The key shift in US macroeconomic strategy—towards a combination of fiscal expansion plus monetary tightening—will complicate matters in the global economy. The financial markets are pricing in three rate hikes by the US Federal Reserve this year, even as it shrinks a balance sheet that has been bloated by quantitative easing. Europe also is expected to stop expanding its monetary base as the continental economy bounces back.

The Indian central bank thus needs to worry about the global situation—especially the risks of a reversal of global capital flows in response to higher US interest rates. India has had to bear significant fiscal costs for building up its foreign exchange reserves through sterilized intervention. The war chest may be in play in the coming months in case of a global shock. What is clear is that interest rate differentials will have to be maintained—or even reduced—in case the risk of capital outflows becomes a reality.

The underlying economy is clearly gathering momentum. The closing of the output gap could allow companies to increase prices to drive earnings. The Economic Survey did well to define the economic challenges of 2018 in terms of the two themes of revival and risk. Indian macro fundamentals are now far better than they were during the rupee crisis of 2013, but policymakers need to be careful. It does not take much for India to shift towards fiscal profligacy combined with loose monetary policy even as inflation rises.

The Narendra Modi government has done well to focus on macro stability in its first four years—undoubtedly helped by the decline in global oil prices after 2014. The situation is now quite different, and the general election is approaching. The political economy challenge of managing the terms of trade between agriculture and the rest of the economy—or what this newspaper has described as the impossible fiscal trinity—remains unresolved.

Rising domestic inflation, the tightening financial conditions in the global economy and the chances of fiscal deterioration before the next general election provide enough reason for monetary policy vigilance. The game has changed.

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