While markets have welcomed the neutral stance, a glass half full could equally be seen as one half empty
The markets quickly digested the Reserve Bank of India's second rate hike in as many policy meetings. An increase of 50 basis points for the year was always on the cards, and the hikes seem to have been front-loaded. The neutral stance is comforting in the near term, and going by the bond market's reaction, it seems the central bank will now be on an extended pause.
Source: Reuters
However, there is an element of uncertainty that this policy introduces, and it lives in the fine print, which appears to suggest that future rate action is largely contingent on global factors, including the intensity of trade wars across the globe and movement in commodity prices.
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While acknowledging several factors that could probably have a sobering effect on inflation in the medium term, the central bank still voted by a majority (five out of six) in favour of a 25 basis points hike in repo rate as it felt that the headline is still far from the targeted inflation rate of 4 percent.
Why hike rates now?
Emerging data points have surprised negatively in the recent past, with reported Consumer Price Index (CPI) rising to 5% in June 18 from 4.87% in May, thereby overshooting the RBI's comfort zone. What is worth noting is the movement in core inflation (a measure that excludes transitory or temporary price volatility as in the case of food items, energy products), which has been inching higher month after month and touched a high of 6.5% in June.
Source: MOSPI, Moneycontrol Research
While the first rate hike in June was intended to rein in inflationary expectations, the concern hasn't dissipated. The central bank cited that its latest survey of households reported a further uptick of 20 basis points in inflation expectations in the near as well as in the medium term. A survey of manufacturing firms showed higher input costs and selling prices, and manufacturing as well as service PMI (purchasing managers' index) indicated elevated input prices. Finally, while rural wages have been moderate, wage growth in the organised sector remained strong.
But RBI noted that rural purchasing power can see a revival, thanks to the significant hike in minimum support prices (MSP) for kharif crops, which is much larger than the average increase seen over the past few years. The MSP hike will have a direct impact on food inflation and second-rung effects on headline inflation.
Last but not the least, the risk of fiscal slippage is high in a pre-election year and could have adverse implications for market volatility, reduce private investment and impact the outlook for inflation.
The inflation forecast for the medium term reflects the central bank's slightly cautious stance on inflation and its comfort on the growth front.
Source: RBI
Growth isn't a cause for concern as various indicators suggest that economic activity has remained strong. The progress of the monsoon and a sharper-than-usual increase in MSP is expected to boost rural demand and recently-announced earnings of fast moving consumer goods companies reflect this buoyancy. Investment remains firm despite tightening financial conditions, and higher foreign direct investment and supportive capital market conditions augur well for investment activity.
The mitigating factors prompting a neutral stance
Having expressed its concern, the RBI also alluded to several mitigating factors that should raise hopes of an extended pause on interest rates.
On the domestic front, south-west monsoon has been recovering and the live storage in major reservoirs is improving, which portends well for the rabi sowing season. This should help food inflation.
Crude oil prices, although elevated, have moderated slightly in recent times. The central government has reduced goods and services tax (GST) rates on several goods and services. These factors should have a sobering impact on inflation.
Economic activity in major emerging market economies has slowed on volatile and elevated oil prices, mounting trade tensions and tightening of financial conditions. The Chinese economy lost some pace in Q2, pulled down by efforts to contain debt. These could adversely effect India's exports and have already had a sobering impact on commodity prices.
Source: Reuters
Crude prices, nevertheless, will remain a joker in the pack and could rise in the face of geopolitical tensions and supply disruptions. It could also fall if global demand sputters because of intensifying protectionist trade policies.
In sum, while the markets have welcomed the RBI's neutral stance, a glass half full could equally be seen as one half empty. An extended pause indicates global growth concerns that could have dampening long-term implications for India's growth.
At the same time, de-escalation of global tensions could mean firming up of commodity prices, rising inflationary pressures, and faster rate hikes by central banks across the globe by the RBI. After the latest policy review, with a neutral stance, we are back to the classic dilemma of growth versus inflation.