Monetary Policy: Don’t Write Off That Rate Hike, Just Yet

Can inflation really continue to lag the strong recovery in growth?

Markings sit on a road on  May 14, 2017. (Photographer: Matthew Lloyd/Bloomberg)
Markings sit on a road on May 14, 2017. (Photographer: Matthew Lloyd/Bloomberg)

The Monetary Policy Committee’s lone hawk, Michael Patra, stuck firmly to his view in the latest policy meeting, again advocating a for a rate hike. What prompted him to do this, given the central bank lowered its inflation forecast for 2018-19? Full details will only be available when the minutes of the April meeting are released, and we await with interest his views on inflation in particular. But what is evident from yesterday’s monetary policy statement is that the Reserve Bank of India is increasingly confident in the growth outlook. At Oxford Economics, we tend to agree. Our own FY19 growth forecast for India is just a shade lower than the RBI’s, at 7.3 percent.

Some may find this level of optimism questionable, especially given the recent escalation in trade frictions globally. Admittedly, global trade momentum will likely falter as demand from China cools and higher tariffs kick in. But Indian exports should still not fare too badly compared to last year, as the export-oriented sector recovers from the throes of the Goods and Services Tax and demonetisation. Furthermore, India’s limited involvement in China’s supply chain provides a buffer against any further fallout from ongoing trade tensions between China and the United States.

In any case, domestic demand is India’s real hero and this is where we look for greater traction this year. Bottom-up indicators, such as auto sales and Services Purchasing Managers’ Index, clearly show that consumption, which accounts for around 60 percent of GDP, has recovered from the lows of the disruptions related to demonetisation and GST. Even more positive are the signs of a turnaround in manufacturing, and in turn, private investment. The Nikkei India Manufacturing PMI has been in expansionary territory (above 50) for eight consecutive months now, and industrial production growth has surged significantly since late 2017.

Monetary Policy: Don’t Write Off That Rate Hike, Just Yet

Furthermore, the FY19 budget placed a clear emphasis the need for additional infrastructure spending, raising the allocation of funds to roughly Rs 6 lakh crore, from Rs 5 lakh crore in FY18, a 20 percent increase. So, although a return to the double-digit investment growth rates of the mid-2000s is unlikely in the near-term, we do expect investment growth to accelerate from the levels of FY18, contributing to more broad-based growth outlook for domestic demand this year.

The Goldilocks combination of high growth and low inflation is definitely alluring for investors and the bond market, in particular, has heaved a huge sigh of relief after a period of well-documented troubles.

But can inflation really continue to lag the strong recovery in growth?

RBI’s inflation forecast downgrade largely reflects the benign trajectory of food prices so far this year, as well as prospects of a normal monsoon season. But close followers of India need no reminder of how volatile food inflation can be and as a result, how much inflation projections can vary from the actual outcome. Also, a clearer picture of food inflation will only emerge once the impact of revised MSPs (Minimum Support Prices) can be ascertained.

So, a focus on underlying inflation dynamics is warranted. First, the output gap is narrowing, which is exerting upside pressure on core inflation.

‘Core-core’ inflation (CPI excluding food, fuel, and motor fuels) has climbed above 5 percent in the last couple of months, which is noticeably higher than the level prevailing in mid-2017 of just over 4 percent.

Second, fiscal slippage risks persist both at the centre and state levels, with the likelihood of higher expenditure high during an election year. Third, a weaker rupee and possibly greater pass-through from global oil prices to domestic fuel prices are likely to increase the external pressure on domestic prices. All these factors point towards rising inflationary pressures, with headline inflation likely to remain comfortably above 4 percent throughout FY19. Indeed, as the RBI itself notes, risks to its inflation forecast are all to the upside.

Hence it would be premature to write off the prospect for a rate hike just yet. And while the RBI operates under an inflation targeting mandate, the implications of a prolonged pause in an environment of rising global rates cannot be completely ignored. As our Asian neighbours have shown, even in an environment of controlled inflation, signalling an end to the accommodative stance may be required to contain financial stability concerns. Faced with a combination of high trade deficit and slowing capital flows, this is not a step that the RBI can completely choose to ignore.

Priyanka Kishore is Lead Asia Economist at Oxford Economics.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.