The Indian financial markets are "too focused" on the actions of the US Federal Reserve as a determinant of the Reserve Bank of India's (RBI) policy, according to Ashima Goyal, one of the three external members on the Indian central bank's Monetary Policy Committee (MPC).
"The problem is the market is too focused on what the US Fed does," Goyal told Moneycontrol in an e-mail interview. "They need to understand India's macroeconomic conditions give policy some freedoms to respond to domestic needs, and to do what is best for reducing Indian inflation while sustaining its growth."
Multi-decade high inflation has forced the US Fed to increase interest rates sharply this year, with the federal funds rate target range currently at 2.25-2.50 percent, up from 0-0.25 percent in early March.
As per the CME's FedWatch Tool, prices of Fed Fund futures contracts suggest there is a 52.5 percent probability of the Federal Open Market Committee (FOMC) – the Fed's rate-setting panel – increasing interest rates by 50 basis points next month and a 47.5 percent chance that the hike will be 75 basis points.
The FOMC is scheduled to meet on September 20-21, a week before the MPC sits on September 28-30.
Rupee pressure
The rapid tightening of monetary policy in advanced economies was sparked by the rise in global commodity prices following Russia's invasion of Ukraine, which also widened India's trade deficit and exerted pressure on the rupee.
Since the invasion in late February, the rupee has depreciated by more than 6.5 percent against the US dollar and breached the 80-per-dollar mark for the first time on July 19. The rupee's wekness has forced the RBI to draw upon its foreign exchange reserves to defend the currency and reduce exchange rate volatility, fuelling talk of whether of the MPC needs to keep pace with the FOMC's rate hikes to ensure the difference between India and US interest rates does not reduce and lead to further weakness in the Indian currency.
But Goyal, emeritus professor of economics at Mumbai's Indira Gandhi Institute for Development Research, rejected talk of the rupee's exchange rate and the US-India interest rate differential being determinants of Indian monetary policy during the MPC's August 3-5 meeting.
"India's flexible inflation-targeting framework is mandated to respond only to inflation and growth. The repo rate does not respond to the exchange rate… Moreover, the interest differential with the US has only a minor and possibly perverse effect on capital flows," Goyal wrote in her statement, according to the minutes of the meeting, released on August 19.
Easing inflation
What the MPC is focussed on is its mandate – inflation and growth.
Although headline retail inflation in July came in above the RBI's medium-term target of 4 percent for the 34th consecutive month, at 6.71 percent, it was the lowest in five months.
"We are finally seeing commodity prices falling and supply chain issues being resolved. Excess inventories with firms are putting downward pressures on demand and prices. So we may see inflation fall faster than expected," Goyal said, pointing out the RBI's one-year-ahead inflation forecast prior to the Russia-Ukraine war was 4.5 percent.
The RBI's latest forecasts peg average Consumer Price Index (CPI) inflation at 7.1 percent for July-September, 6.4 percent for October-December, 5.8 percent for January-March 2023, and 5.0 percent for April-June 2023.
Given the forecasts and the fact that CPI inflation averaged 6.3 percent and 7.3 percent in the first two quarters of 2022, respectively, the RBI is currently on track to fail its mandate, which is defined as average inflation staying outside 2-6 percent for three consecutive quarters.
Despite the exceptional circumstances caused by back-to-back shocks and the country's sensitivity to crude oil prices, Goyal said deviations in domestic inflation from target have been much lower in India than in other countries.
"Since monetary policy works with lags there is no way it can reduce sharp crude oil price-induced inflation spikes within three quarters. In the Indian context, steep rate hikes have more impact on output than they have on inflation," she noted.
GDP growth
Over the past three-and-a-half months, the MPC has increased the repo rate by 140 basis points to 5.4 percent, with Goyal writing in the minutes released last week that the rate hikes had "not as yet slowed the recovery."
The RBI expects India to post a GDP growth of 7.2 percent in FY23.
"If there is a global slowdown, 7 percent-plus will be a very good growth rate for India to achieve. It may fall towards 6 percent in FY24," Goyal said.
The three repo rate hikes since the start of May have led to a debate on when the committee might take a breather. However, the immense uncertainties make it difficult to define a neutral rate or terminal repo rate and provide a stance on that basis, Goyal said.
Asked to comment on fellow-external member Jayanth Varma terming the MPC's decision to remain focused on withdrawal of accommodation as confusing, Goyal said that part of the resolution clearly referred to liquidity.
"It has been clarified that withdrawal of accommodation is defined in terms of liquidity, so the market should not infer anything about the terminal repo rate from the stance," she said.