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The Monetary Policy Committee (MPC) has hiked the policy repo rate by 25 basis points, taking it to 6.5 per cent. This is the first time we have a situation where the MPC since its inception has increased rates at two consecutive meetings. Thus, the policy repo rate, which (over time) drives the rate at which banks lend to customers, has moved up from 6 per cent to 6.5 per cent in the last four months. The MPC wants this increase to “bite” (in the words of the RBI Deputy Governor and MPC member Dr. Viral Acharya) so that inflation is checked.
Core inflation has been on an uptick since the beginning of the current fiscal and has remained at a higher level of 6.53 per cent in June 2018. Items like housing, education, health and recreation & amusement broadly form part of core inflation. Officially, the MPC does not talk of core inflation but this calculation informs its understanding of headline inflation, which is the target the MPC looks at.
What this tells us is that there is a nagging underlying strain on the inflation front.
The retail inflation rate measured in terms of the Consumer Price Index was at 4.9 per cent in May 2018 and 5 per cent in June 2018. This headline number is at a level higher than the inflation target of an average 4 per cent that the MPC is mandated to maintain. The inflation number looks uglier when we calculate core inflation, which is the headline number adjusted after removing sensitive items like food and fuel. Core inflation has been on an uptick since the beginning of the current fiscal and has remained at a higher level of 6.53 per cent in June 2018. Items like housing, education, health and recreation & amusement broadly form part of core inflation. Officially, the MPC does not talk of core inflation but this calculation informs its understanding of headline inflation, which is the target the MPC looks at.
The red flags on inflation come against the backdrop of a comfortable outlook for economic growth, which stands above 7 per cent for the current fiscal and going up to 7.5 per cent in the first quarter of the fiscal year 2019-2020. Alongside, the output gap (the gap between potential output ad actual output) has almost closed, indicating that the economy is producing near its potential. This comfort left the MPC solely focused on inflation and inflation expectations as the issue to be managed.
One of the worries outlined by the MPC is the increase in the Minimum Support Price (MSP) for agri produce, which could contribute to higher food inflation. This alongside the high crude oil price, coupled with volatility in the financial markets, would also adversely impact the outlook on inflation. An even more worrisome feature is the household inflation expectation, which has risen sharply and has the potential to stimulate actual inflation outcome. Another adverse factor is the fiscal situation at the Central and in the States. As recent evidence suggests, fiscal slippages (adverse deviations from the budget estimates) has been a rule rather than the exception. Such slippages are likely to negatively impact the inflation outlook, apart from the downsides like volatility in financial market and increased borrowing by governments, leading to “crowding out” of private investment.
Thus, there is a threat of inflation from three fronts: food inflation, fuel inflation and core inflation. When inflation persists and becomes all pervasive, the management of inflation becomes priority through a policy repo rate hike. The gold standard of policy is to beat the beast before it can raise its head because once it does, it will require far more beating to tame it.
Yet, it bears looking at how today’s action will find its way over time into the rate at which the banks lend to their customers. Normally, a change in policy repo rate works through the interest rate channel, moving from the shorter end of the market i.e. the call money rate (overnight interbank money market rate) to the longer end of the market (the rates for 10 year bonds) and then to the bank lending rate, where the pinch is felt by the customer.
Evidence suggests that the increase in policy repo rate with some lag does impact the bank lending rate and discourage the demand for consumption. This could also impact investment. In other words, the policy repo rate hike and subsequent increase in bank lending rate while moving the economy to a “disinflationary glide path” (to anchor inflation expectation) calls for some sacrifice, and this sacrifice comes in a lowering of economic growth.
In an open and globalised economy, currency movement (through the exchange rate channel) also has a role to play in the transmission mechanism of monetary policy, and can impact the interest rate. This aspect merits attention, particularly in the context of the so-called impossible trinity. A country cannot have a three-cornered solution – a fixed/flexible exchange rate, free capital mobility and independent monetary policy. One of the three has to give way.
However, the MPC’s outlook on economic growth stands today at 7.5 per cent in Q1 of 2019-20, which reflects an optimistic bias. The hope that inflation can be lowered without sacrificing growth is likely to be in vain.
One crucial aspect is the RBI’s stance on liquidity management, which continues with a neutral stance. This means the RBI would work to keep liquidity in the system neither in deficit nor in surplus mode. But with two consecutive increases in the policy repo rate, adhering to a neutral stance may not be the best course of action because the system may require some accommodative stance as it adjusts to the tightening. In principle, the RBI remains committed to a neutral stance. The market has to therefore read and accordingly adjust cash management.
The MPC assessment does not make any explicit mention on the currency movement in India. But we have a rising current account deficit and net capital outflows, which could impact currency movement and the liquidity management. Could the higher interest attract more dollars to India? This has to seen in the context of the strengthening US economy, the US Fed rate hike and subsequent dollar appreciation. In an open and globalised economy, currency movement (through the exchange rate channel) also has a role to play in the transmission mechanism of monetary policy, and can impact the interest rate. This aspect merits attention, particularly in the context of the so-called impossible trinity. A country cannot have a three-cornered solution – a fixed/flexible exchange rate, free capital mobility and independent monetary policy. One of the three has to give way.
In sum, the decision by the MPC is the right step at the right time. It’ll help meet the legislative mandate of the monetary policy, which is “price stability, keeping in mind growth.”
(Pattnaik is a former Central banker and Rattanani is a journalist. Both are faculty members at SPJIMR)