Monetary Policy Tightening: When And How Much?
The Indian economy is at a critical juncture. Domestic headwinds from 2017-18 have started to wane with sufficient progress in remonetisation and ongoing acclimatisation to the Goods and Services Tax related structural overhaul in indirect taxes.
The rear-view mirror gives a comforting view. Despite the moderation in FY18 growth momentum, incrementally, gross domestic product growth accelerated sharply to 7.4 percent in the second half of FY18 from 6.0 percent growth seen in the first half of FY18. Average Consumer Price Index inflation fell below the medium-term target of 4.0 percent to 3.6 percent in FY18. Notwithstanding the minor deterioration, the twin deficits were comfortable. A surfeit of capital inflows resulted in record high foreign currency reserves, which in turn had a salubrious impact on domestic interest rates and the rupee.
On these observations, one could possibly conclude that the Indian economy is in a Goldilocks scenario.
However, this comfort is unlikely to continue much into FY19 with the telescopic view starting to highlight the emergence of global headwinds.
Let’s look at what has changed off late. In a nutshell, geopolitical developments have become unpredictable and volatile, amplifying the ‘known unknown’ and the ‘unknown unknown’ risks.
The initial unprecedented shock came in the form of purported threat to the structures of globalisation, which manifested in the form of ‘trade skirmishes’ between the United States and some of its key trading partners. While these skirmishes have been high on decibel so far, further mutualisation of threats could impinge upon global trade activity including global commodity prices.
This was soon followed by the spectre of rising crude oil prices, which reflected adverse geopolitical developments ranging from U.S. sanctions on Iran to Venezuelan politics. With crude oil prices jumping by around 29 percent on a fiscal year-to-date basis, for countries like India that import around 83 percent of its oil consumption, the macro consequences in the form of inflation and twin deficits could start posing challenges.
Last but not the least has been the recent political gyrations in the third and fourth largest economies in the Eurozone – Italy and Spain. Political instability is bound to impact economic performance in Eurozone, but more importantly, it has the potential to get cataclysmic if financial markets start focussing on the survival of the Euro, like they did during the 2010-2012 crisis.
These adverse global shocks are likely to weigh upon the thought process of the members of the Monetary Policy Committee, who would meet over the next few days for a review of the domestic monetary policy.
In the current environment, the central bank seems to be facing a mild version of the ‘Impossible Trinity’ amidst a combination of various negative global shocks.
This has already started to stoke capital outflows by foreign portfolio investors to the tune of $ 7.1 billion on a fiscal year-to-date basis, resulting in pressure on the rupee. While the macro-financial situation is not as dire as it was in 2013—which necessitated a drastic policy response—the financial markets are now likely to focus on the third angle of the trilemma, which is the independence of monetary policy under such a scenario.
The theoretical response towards the assertion of monetary policy independence for an inflation targeting central bank under such a scenario would be to tighten interest rates. Indeed, the RBI would find company in this.
Central banks in Indonesia, Philippines, and Turkey have announced rate hikes over the last few weeks to ward off inflation pressure and protect their currency from any further excessive weakening.
Should the RBI then succumb to peer pressure? In my opinion, the negative global shocks provide the ‘necessary’ condition for altering the course of monetary policy – from neutral towards the withdrawal of accommodation. However, on their own, they are not ‘sufficient’. Let us consider some of the factors which warrant caution at this juncture while maintaining a tight vigil.
Beware the inflation solstice in June 2018: Recall, CPI inflation in June 2017 had dipped to a series low of around 1.5 percent. Hence, the statistical base for Jun 2018 will be at its extreme worst.
This is likely to push June inflation towards the upper band, around 5.5-6.0 percent.
This is likely to form the peak for FY19, after which inflation is expected to gradually moderate towards 5 percent levels by March 2019.
Food inflation negatives to get partially offset by positives: The government is expected to announce a significant rejig of the Kharif minimum support prices in FY19 by fixing it to 1.5 times the cost of production. This could add around 50 basis points to headline inflation with half of that impact coming in FY19. While this could have an adverse spillover on secondary market food prices, the chances of a blowout are extremely low as the India Meteorological Department forecasts a normal monsoon out-turn with cumulative seasonal rainfall expected at 97 percent of long period average.
Political sensitivity providing some shock absorbers: Despite a sharp jump in international crude oil prices, domestic retail prices have not seen a commensurate increase. The adjustment remains partial with the burden of adjustment shared by the government, via a cut in taxes on fuel, and oil companies, via higher under-recoveries.
This could enfeeble the overall threat of oil prices on inflation.
Productivity gains: Not everything about inflation is cyclical/seasonal. Gradual productivity improvement could start trickling in with structural changes on account of GST and the Insolvency and Bankruptcy Code. A similar productivity boost was observed in 2000-05 on account of rapid development in two sectors – spread of roads and highways, and information and communications technology services across the country.
Structural boosts like these to productivity are often associated with benign inflationary conditions.
Having highlighted the reasons for maintaining caution, one also needs to consider the other side of the argument as well. After all, the underlying inflation momentum is expected to pick up in FY19 towards 4.9 percent, with some of the acceleration attributable to the elimination of the erstwhile negative output gap. Cognizant of such an outcome, the MPC’s sensitivity to core inflation—a proxy for demand-side pressures in the economy—will get heightened. The anticipated 80 basis points deterioration in current account deficit towards 2.6 percent of GDP in FY19 is also likely to be viewed in similar light. Deterioration in the current account deficit above 2.5 percent has other systemic implications for domestic money market, especially in an environment characterized by global pressure on capital inflows towards emerging market countries.
All these are presumptive risks which the central bank as the guardian of financial stability eventually needs to take into account while setting monetary policy so as to anchor expectations of major economic stakeholders.
This brings us back to the question of whether the MPC should consider monetary tightening? This is one question that manages to evoke passionate arguments from both sides of the fence.
Given the balance of risk, I believe that monetary tightening in India is now a matter of ‘when’ rather than ‘if’.
From this perspective, August stands a better chance than June as the former could allow MPC members flexibility to make a more informed decision basis the progress of south-west monsoon, waning of distortionary statistical base effect, the announcement of MSPs, and OPEC’s semi-annual meet.
Furthermore, the RBI could also consider an increase in its balance sheet through OMOs, which in turn can have a calming impact on yields.
Given the nature of argument involved on both sides, the final decision on when to turn the monetary policy cycle will be a close judgement call. Whatever be the outcome, it gives me a great sense of comfort that policy credibility with respect to inflation in India has taken a giant leap in 2018 vis-à-vis 2013, with the halving of underlying inflation, and with less-debated harsh policy choices in the past paving way for strongly-debated policy tweaks.
Shubhada Rao is group president and the chief economist at YES Bank.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.