In a unanimous decision, the monetary policy committee (MPC) has raised the repo rate by 25 basis points, while maintaining a neutral policy stance. This was the first rate hike since January 2014. The Reserve Bank of India (RBI) also increased its FY19 inflation forecast for the second half of the year to 4.7% from 4.4%, while keeping its growth forecast unchanged at 7.4%. Crucially, the balance on risks on inflation is seen remaining titled on the upside.
While the policy action was largely anticipated, the unanimity of the decision is an important signal.
Given the unexpected pick-up in core CPI (Consumer Price Index) inflation in April and two key upside risks to the inflation trajectory for the current year materialising in the form of higher oil prices and a weaker rupee, a rate hike had become imperative.
Besides, the ongoing retrenchment of capital from emerging markets on the back of higher US yields and a stronger US dollar and the resultant pressure on emerging market (EM) currencies, has led to some of the EM central banks to raise rates to support their currencies.
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This too increased the need for monetary tightening, as otherwise a weaker rupee feeds into inflation via higher cost of imports. And, in an inflation targeting framework, where the policy instrument to target inflation is the monetary policy rate, any sustainable risks to inflation from exchange rate depreciation have to be managed through policy rate increases.
This backdrop and a stronger Q4 GDP reading seem to have driven the MPC consensus on a rate hike—a sign that all members are now more concerned about the inflationary pressures and the risk to the 4% inflation target. Indeed, the headline CPI inflation has now exceeded this target for six consecutive months. In the past, some of the members had expressed a greater concern about growth being below potential and have therefore either voted for status quo or a rate cut. The fact that the output gap has almost closed (as noted in the monetary policy statement) and improving growth prospects, appears to have laid those anxieties to rest.
By maintaining the policy stance as neutral, the MPC has signalled that the future path of the policy rates would remain data dependent. Future policy action would therefore depend upon (1) how persistent the oil price increase seen so far this year proves and how much of a pass-through is made to domestic prices; (2) how the new MSP procurement formula announced in the budget influences food inflation and generalised inflation; and (3) how global financial markets and trade conditions evolve from the current setting.
Oil prices can ease from current levels if Opec in its June meeting decides to increase output. However, the increase seen this year appears durable. Global financial conditions may continue to support tightening, as emerging markets facing a dollar liquidity squeeze continue to witness a downward pressure on their currencies. The rupee too continues to witness similar pressure. Food inflation from hereon is likely to move higher, as the government implements its budget proposal of ensuring remunerative prices for farmers and as seasonal hardening/ mean reversion in farm prices sets in. For instance, in the case of pulses, the average deflation in FY18 was 21%, which in turn shaved 0.5% from the headline CPI inflation.
It’s quite likely that government procurement and price action this year would ensure that pulses deflation is arrested. And, that in turn could at the very least reduce this negative contribution to headline inflation. Moreover, household inflation expectations for the near term and one year ahead have inched up sharply in their May reading. And, input cost pressures in the manufacturing sector continue to build, which can lead to higher output price inflation as demand conditions improve.
Thus, in all likelihood, the next policy move may turn out to be another hike but that may now only happen in the second half of the fiscal year. The minutes of this meeting will be eagerly awaited to establish various factors that the members considered in making their decision, their orientation towards further tightening and factors which could drive a move to a “restrictive” policy stance. The minutes of the April meeting provided a clear precursor to the MPC view shifting towards monetary tightening, despite the policy statement projecting lower inflation in FY19 compared to the February statement.
Gaurav Kapur is chief economist at IndusInd Bank. Views are personal.