Monetary policy can only turn hawkish

The second bi-monthly Monetary Policy Committee (MPC) meeting for 2018-19, which will release its reading of the economy on Wednesday, comes amid a complex mix of indictors. On the one hand is the euphoria of the 7.7 per cent GDP growth for the fourth quarter for 2017-18 as announced last week, the fastest pace of growth in the last seven quarters. On the other hand is a dismal picture on inflation, compounded by a spurt in the prices of international crude, which has already brought into play macroeconomic as well as political forces as fuel prices at the local petrol pump move up.

The overall growth signals both from the demand side (consumption and investment) and supply side (agriculture, manufacturing and services) are encouraging. There is a consensus that there are signs of revival of investment activity with manufacturing output showing strong revival and indicating higher capacity utilisation. The output gap (actual output minus potential output) is more or less closing. The services sector in terms of the Purchasing Managers’ Index (PMI) has grown. A growth rate of 7.4 per cent for 2018-19 projected in the April 2018 monetary policy committee augurs well given the current global and domestic economic scenario. In that sense, growth is on track.

However, there are some fundamental concerns as the structural impediments to growth predominate. These include the uncertainty in agriculture growth given the dependence on the monsoons, the predominance of consumption-led growth due to persistence of revenue deficit of the government and the recent heavy toll on the net export on account of rising international crude prices.

Evidence suggests cyclical factors contributing to lower growth are receding. Therefore, an easy monetary policy (or lowering of interest rate) to boost aggregate demand will not yield the desired impetus at this stage. The predominance of structural factors as impediments to growth call out to being addressed by supply side management which means driving efficiency and productivity across sectors, and particularly agriculture.

It is the emerging situation on inflation that is particularly worrying. While presenting the April 2018 inflation outlook, the MPC resolution projected retail headline inflation measured in terms of combined (both rural and urban) Consumer Price Index (CPI-C) for 2018-19 in the range of 4.7-5.1 per cent in H1 of 2018-19 and 4.4 per cent in H2. Since then, the inflation situation has been adversely impacted by the foreseen and the unforeseen.  Oil prices were unforeseen; the government had betted and argued too much on international crude being capped at USD 50 a barrel.  It didn’t take long for anyone to realise that all of this was wishful thinking. In addition, there are pressures from the substantial upward rise in Minimum Support Prices (MSP), the second round effect of House Rent Allowances (HRA), hardening of international non-oil commodity prices and the swelling of fiscal deficit, both at the Central and the State level.

CPI (Combined) headline inflation in April 2018 at 4.58 per cent  as compared to 2.99 per cent in April 2017 has moved to a higher trajectory, crossing the average inflation data of 4 per cent officially recognised as the inflation target. Food inflation has decelerated to 3 per cent. But persistence of inflation measured in terms of core inflation (excluding food and fuel) in April 2018 is an important red flag. Calculations show that the core inflation number stands at as high as 6.19 per cent.  It may be mentioned that the core inflation has been stubborn at more than 5 per cent since December 2017. This poses a serious challenge for the RBI to maintain and sustain the 4 per cent inflation target.

This challenge is corroborated by two lead indicators – the inflation expectation of households and industrial outlook survey by the RBI. The former paints a higher inflation outlook and the latter presents the possibility of rise in input prices.

In view of these developments, there are grounds to believe that MPC will make an upward revision of retail inflation target for 2018-19 which could be closer to the upper ceiling of 6 per cent in the inflation targeting framework. 

In addition to the adverse inflation scenario, the swelling of CAD-GDP ratio to around 2.56 per cent due to a sharp increase in oil prices poses a serious challenge to RBI to arrest the rupee depreciation. Quick calculations show that the scenario gets worse if oil prices persist around 80 dollars or go higher, which could take the CAD-GDP ratio to as high as 2.9.

As the RBI sells dollars to maintain orderly conditions in the market, there will be adverse implications for the interest rate on the rupee. In other words, to ease dollar liquidity, there will be pressure on rupee liquidity, impacting the interest rate. Adding to the dynamic will be the unstated worries of higher government spending as the nation prepares for national elections by 2019.  A higher revenue deficit leading to a higher fiscal deficit will also put pressure on the rupee interest rate.  Already, the market interest rates and particularly the government 10-year bond yield has moved up.

In view of the above, MPC will likely have a wait and watch approach, looking for directional signs on the monsoons and trends in oil prices. This means maintaining the status quo by keeping the policy repo rate at 6 per cent. However, the spirit and tone of the MPC is expected to be hawkish. Less will be said by the numbers and more by the language of the MPC. This may well set the tone for a policy repo rate increase going ahead.

(Pattnaik is a former central banker and Rattanani is a senior journalist. Both are faculty members at SPJIMR)