Why the RBI cannot afford to pause

Inflation, fiscal slippages and a weak rupee call for more rate hikes this year

In the run-up to the monetary policy announcement, there were heated debates on RBI’s policy action.

Surprisingly though, the deliberations were not on whether the central bank would hike rates once again — almost everyone seemed to be in accord with a 25 bps hike in repo rate. The endless to-and-fro was on whether the RBI would stick to its neutral stance or turn hawkish/dovish.

These bird references to RBI’s policy stance reminds one of Urjit Patel’s elaboration on Raghuram Rajan’s remark of the RBI being an owl — a symbol of wisdom and vigilance.

It is this wisdom and vigilance that is now called for, in light of growing macroeconomic imbalances. While the RBI retaining a neutral stance has offered markets a much needed respite, it hardly rules out possibility of further rate hikes, going by the RBI’s own assessment of underlying risks to inflation. Importantly, as concerns over fiscal slippages, falling rupee and tightening of global liquidity take centre-stage, the RBI can ill-afford to let its guard down.

On the rise

CPI (consumer price index) inflation shooting up to 5 per cent in June, beyond the RBI’s comfort zone, has been driven by the sharp rise in core inflation to 6.4 per cent, close to a four-year high. Components such as clothing and footwear (6.53 per cent weight in CPI), housing (10 per cent), and miscellaneous (28.3 per cent) — all have witnessed an up-tick in recent months. Housing inflation has been moving up sharply — from 6.1 per cent in September 2017 to 8.45 per cent in June 2018. While lowering of GST rates for certain commodities can lead to some interim moderation in core inflation, there is unlikely to be a sharp fall.

Rise in global crude prices have led to fuel inflation moving up to 7.14 per cent in June from 5.8 per cent in May. While prices have marginally fallen since the last monetary policy, uncertainty over future price movements persist.

Upside risks

While the RBI may have retained its neutral stance, inflation risks highlighted by it defiantly indicates hawkishness. Uncertainty over crude prices, volatility in global financial markets, significant rise in households’ inflation expectations, rising input costs, fiscal slippage at Centre and State level, higher-than-average hike in MSPs (minimum suppport prices) for kharif crops and staggered impact of HRA rise — are risks underlined by the central bank that are real. The modest revision in inflation forecast for the second half of FY2019 to 4.8 per cent from 4.7 per cent earlier, hardly factors in these risks.

It is true that increase in minimum support prices may not necessary mean a rise in inflation — in the past, weak procurement, coupled with oversupply issues, has led to fall in prices despite MSP hikes. That said, given the sharp increase in MSPs this time around — far higher than those seen in the past few years — there is likely to be some impact on inflation. Uncertainty over the progress of monsoon could also play spoilsport.

Core CPI inflation (excluding food and fuel), which continue to remain elevated, is also unlikely to come down in a hurry. Rise in government spending could also provide a fillip to consumption, thus exerting upside risks to core inflation.

We believe CPI inflation could move beyond 5 per cent in the second half of FY2019, given that it has already touched the 5 per cent mark. This could prompt another two rate hikes by the RBI in FY2019.

Macro picture

Macroeconomic imbalances are back in focus. The rupee is one of the worst-performing currencies this year, depreciating 7 per cent against the US dollar. The pressure on the Indian currency is likely to stay. While our reserves are way above the abysmal levels seen in 2013, they have been falling over the past 2-3 months, coming off a peak level of $426 billion in April to $405 billion as of July 20. With FPI outflows from the Indian debt market intensifying, sustaining reserves could become difficult. FPIs have pulled out about $6.19 billion out of Indian debt so far this year.

Trade and current-account deficits, too, have been widening over the past few months.

Besides, fiscal deficit has reached 68 per cent of the target so far. Concerns over GST collections, post lowering of rates and increase in government spending in the run-up to the general election in 2019, have increased the risk of fiscal slippage.

The Centre had planned a gross market borrowing of ₹6.05 lakh crore for FY2019. Of this, it has budgeted to borrow just 48 per cent, or ₹2.88-lakh crore, in the first half of this fiscal. This is not just way lower than the ₹3.7-lakh crore of borrowing it did during the first half of the previous fiscal, but also the lowest proportion of first-half borrowing in percentage terms in many years. As of July 20, the Centre has done only about ₹1.68 lakh crore of borrowings. Heavy borrowing (supply of bonds) in the second half of FY2019 could lead to rise in bond yields. Aside from the uncertainty over the Centre’s fiscal policy, rise in States’ fiscal deficits is also a concern.

With the big picture on macros sombre, the RBI can no longer stay on the sidelines. Given that more than one rate hike may be warranted in the remaining part of this fiscal, it may well sound owlish.

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