Wait-and-watch spell is over

One notable thing about the resolution of the MPC to raise the policy repo rate by 25 basis points in its second bi-monthly meeting for the current fiscal year was that it was largely predictable on a close reading of the minutes of its last meeting two months back, as two RBI members were firmly in support of 'withdrawal of accommodation' then, one immediately and the other in June. The opinion of the analysts was divided, though in the lead up to the policy announcement. Most of them expected a hike by 25 basis points in the next meeting in August.

Interestingly, in the wake of the release of the Q4:2017-18 GDP growth rate at 7.7 per cent on May 31, the division of opinion moved a step ahead in favour of a rate hike in the June meeting to 46 per cent as against 40 per cent reported earlier, as per a poll conducted for this purpose. The government securities market seemed to have concurred with the majority view of no rate hike as the yield on the benchmark 10-year paper eased by 5 basis points to close at 7.83% the day before. After the MPC decision, the 10-year yield firmed up a bit to 7.87% but finally ended the day at 7.92%. Incidentally, the MPC took a day more than the usual to conclude its deliberations this time. The issues on the table were varied and complex indeed. 

A rare unanimous decision

MPC's unanimous decision for a rate hike that has come after a gap of more than four years took note of the prevailing good domestic demand condition, particularly in the rural areas on the back of a bumper harvest and the government’s thrust on rural housing and infrastructure. As already widely publicised widely, the economy grew at 7.7% in the last quarter of the fiscal 2017-18 – the fastest pace in the last seven quarters. Also, after quite a while, gross fixed capital formation grew at an accelerated pace during the three consecutive quarters up to Q4: 2016-17.

The demand conditions in the rural areas are likely to be robust in the months to come on the back of a normal forecast for the south-west monsoon rainfall. By all indications, the growth headwinds caused first by the demonetisation of late 2016 and then by the somewhat messy beginning of the GST regime in mid 2017 have finally receded.  The growth performance of the industrial sector looks promising, with the capacity utilisation by manufacturing firms increasing significantly in Q4:2017-18.  Though wage pressures in the rural sector moderated, those in the organised sectors remained firm.

Rising inflation and inflation expectation

On the price front, year-on-year CPI inflation rose sharply to 4.6 per cent in April.  Contrary to the causes of many such episodes in the past, this rise was driven by a significant increase in core inflation, i.e., excluding food and fuel inflation. In fact, food inflation moderated for the fourth successive month in April. Fuel group inflation too declined for the fifth month in a row in April. However, inflation in the transport and communication sub-group accelerated due to the firming up of international crude oil prices, despite the domestic pass-through to petrol and diesel remained incomplete. Inflation rose in clothing, household goods and services, health, recreation, education, and personal care and effects.

The latest round of RBI's survey of households reported a significant rise in households’ inflation expectations of 90 basis points and 130 basis points respectively, for three-month and one-year ahead horizons. Manufacturing firms polled in another survey reported input price pressures and an increase in selling prices in Q1:2018-19. Firms polled for the manufacturing PMI in May also showed a sharp increase in input and output prices. Farm inputs and industrial raw material costs have risen sequentially.

MPC has revised up the projected CPI inflation for 2018-19 to 4.8-4.9% in H1 and 4.7% in H2 from 4.7-5.1 per cent in H1:2018-19 and 4.4 per cent in H2, made at the time of its last meeting in April. It has acknowledged that a major upside risk to the inflation path projected then has materialised, viz., 12% increase in the price of Indian crude basket, which was sharper, earlier than expected and seemingly durable. MPC has recognised the heightened crude price volatility imparts considerable uncertainty to the inflation outlook – both on the upside and the downside.  Another source of uncertainty on the upside is the impact of the revision in the MSP formula for kharif crops.

The growth projection for 2018-19 has been retained at 7.4% as in the April policy. GDP growth is projected in the range of 7.5-7.6 per cent in H1 and 7.3-7.4 per cent in H2, with risks evenly balanced.

Right thing to do in a challenging situation

This meeting of the MPC took place against the backdrop of a challenging macroeconomic and financial market situation involving sharp rise in oil prices since the beginning of this year, a worsening of stretched government finances, expectation that inflationary pressures will rise faster than expected, wider trade deficit, volatile US dollar rupee exchange rate, and large-scale selling by foreign portfolio investors, especially of their holdings of government securities.

It goes to the credit of the MPC that it remained focussed on curbing the rising inflationary pressures in the economy in a pre-emptive fashion when the received wisdom would not have liked to see growth being 'way laid' by rising interest rate. That for nurturing the current positive growth trends in the various segments of the economy a stable inflation environment is needed is a new and welcome realisation on the part of MPC. To be exact, a member of the MPC opined on these lines in the minutes of the last meeting. This approach will enhance the credibility of the MPC and the monetary policy-setting exercise in India, in general.  

Regulatory measures – a mixed bag

The regulatory measures announced in the policy in respect of Valuation of State Government Securities,  harmonising Liquidity Adjustment Facility (LAF) haircuts with global standards, short sale in Government securities, When issued (WI) market in Government Securities and  introduction of capital requirement and governance framework for all CCPs are all welcome steps which will go a long way in modernising the Indian financial markets and make them more efficient, liquid and in reducing  their  systemic risk. 

However, permitting the banks to spread their MTM losses as on June 30, 2018 equally over the following four quarters, as was done for similar losses on end-December, 2017 and end-March, 2017 is clearly a retrograde step. Spreading the recognition of MTM losses is conceptually wrong and goes against the very grain of MTM valuation. MTM gain/loss is different from realised gain/loss on a portfolio of investments or loss on asset impairment.  Spreading of MTM loss has two inherent inconsistencies: If the prices rise subsequently, the banks can legitimately ask for recognising only the net amount. If prices fall subsequently, as has happened since the beginning of the year, more concessions will be needed, as in the current policy.        

Both the lay and the cognoscenti will debate for a long time why MPC has chosen to describe this hike as consistent with neutral stance. It is difficult to surmise if this rise could be a 'one-off' measure, given the facts of accelerating core inflation and strong revival of demand conditions in the economy. If the action of the government securities market after the announcement is anything to go by, RBI is still behind the curve. But on the whole, the policy and its communication are laudable.