The decision on interest rates in the upcoming monetary policy committee (MPC) meeting is likely to be a close call. This is not so much about the case for a hike but rather about the timing.
On the face of it, the case for hiking repo rate once again following the June hike is very much there. Although actual inflation outcomes have been slightly benign in headline terms, core inflation continues to be uncomfortably high. Even if the June reading turns out to be the peak for core, we do expect core inflation to remain north of 5% consistently in the rest of FY19. Though crude prices have softened somewhat since June however rupee has weakened further against the dollar.
The biggest change was the announcement of a sharp rise in support prices (MSP) for summer crops. The increase amounts to 92 bps in CPI weighted terms with cereals contributing 90% of the increase. With government already boasting of a well-entrenched procurement infrastructure for paddy (rice) and committed to ensure that farmers can realize the MSP prices for coarse cereals, pulses and oilseeds, we believe that higher MSPs will flow through to wholesale prices and then on to retail prices.
Our analysis has shown that in the past, the price transmission to wholesale prices was quite rapid whenever there was a sharp rise in MSPs. While there is some uncertainty about the transmission to retail prices, there is a good likelihood that the transmission is largely complete by Q4FY19. Accordingly, we see headline inflation average 5% in that quarter compared to the MPC’s estimate of 4.7%. Further, we expect CPI inflation to average 5.4% in H1FY20, implying sustained price rise due to MSP effects.
Once the MPC starts factoring in second round effects of higher food and fuel price in the backdrop of rising inflation expectations, then the likelihood of core inflation drifting above 5% in FY20 is salient.
For all these reasons, we think the MPC may have to carry out a series of rate hikes through FY20 to prevent inflation from drifting away from the 4% target.
Two other developments add weight to our argument. One is that the central government’s fiscal position is quite weak and is unlikely to improve this year. We expect a fiscal slippage of 0.2-0.3% of GDP on the back of higher spending on procurement, healthcare and lower revenues from GST and non-tax receipts. Even though state governments’ revenue outlook is bright, spending priorities in the form of loan waivers and higher salaries should rule out any improvement in their fiscal metrics.
The other development arguing for higher domestic rates is that the US FOMC is likely to keep pushing ahead with its gradual rate rises. We see the Fed Funds Target Rate hitting 3% in 2019 before the FOMC pauses. By then, it is likely the ECB may start hiking rates. This would imply that global economy continues to expand in the base case.
The risk though is that ongoing trade skirmishes between US and China assume a more serious and durable character and start impinging on trade, corporate profitability and global growth. Be that as it may, in the base case, India’s outlook should continue to be solid with consumption recovery aided by a nascent capex recovery.
Putting all this together, we expect the MPC to hike once by 25 bps by October with risk of one more hike in rest of FY19, even as we pencil in more hikes in FY20.
For the MPC, the decision about August or October might hinge on whether they would prefer to stick to gradual hikes or not. Make no mistake, successive hikes over June and August would push up market expectations of future rate hikes. Further, the MPC would find it difficult to hike in August without changing its stance from neutral. Lastly, the MPC didn’t hint at an August hike either in the June statement or via minutes.
Notably in the April minutes, deputy governor Viral Acharya had guided market that he will switch his vote in the June policy. A less important but nonetheless pertinent issue is that the committee may not be unanimous in its view about the inflationary effect of higher MSPs. Thus, the committee, and in particular the governor, could decide to wait for October for more information on inflation outturns to firm up inflation forecasts. That would also afford the committee more time to decide on a change in stance.
One potential ‘loophole’ that allows for this delay is that the government has not spelt out its preference to implement MSP i.e. direct procurement or price support to augment market prices with the two approaches having different inflation implications.
Lastly, the August meeting would be an opportune time for RBI to come to a decision on its liquidity stance and communicate the same to markets. Its current neutral liquidity stance is incompatible with rate outlook, global developments and its limited toolkit. The sooner the central bank indicates a switch in liquidity stance to deficit conditions the easier it is for market expectations to adjust. Otherwise, bond market pricing could drift away from fundamentals.
Prasanna A. is head of research at ICICI Securities PD Ltd.