On February 7, the Monetary Policy Committee of the Reserve Bank of India decided to maintain a status quo and leave its repo rate at 6 percent and the reverse repo at 5.75 percent. This was in line with expectations of 32 out of 33 economists in the Bloomberg survey prior to the rate decision day but in contrast to our own expectation. We expected the RBI to increase the repo rate to 6.25 percent and the reverse repo to 6 percent, but admittedly, we were wrong. So, why did we bring forward our expected hike in the April-June quarter in the first place?
External Inflation Risks
The external environment has become much more uncertain and volatile. This was also mentioned by the RBI in its policy statement: “the inflation outlook is clouded by several uncertainties on the upside”. More external price pressure is expected on the back of rising oil prices. Brent crude went up from $64 in December to almost $69 in January. More importantly, in the wake of the Budget release on February 1, yields on Indian Treasuries surged, increasing by almost 50 basis points vis-à-vis levels seen in mid-January. Many analysts attributed the rise in Indian bond yields to fiscal relaxation in the budget, as Finance Minister Arun Jaitley announced that the central government fiscal deficit is expected to reach 3.5 percent of GDP in 2017-18, instead of the targeted 3.3 percent.
Our view, however, is that the jump in Indian yields is only partly explained by fiscal slippage, and the larger part of the rise is the result of fast-rising yields in the United States.
Indeed, there have been several indicators that earnings in the U.S. are gaining traction on the back of increasing labour market tightness. Average hourly earnings rose to an annualised rate of 2.9 percent in January. Higher wages might result in higher U.S. inflation and this could encourage the Federal Reserve to speed up its tightening cycle. Markets are already speculating about four hikes this year, instead of three hikes anticipated earlier. These developments illustrate the vulnerability of emerging markets such as India, as capital might be drained at a fast pace, which most definitely will have negative consequences for debt sustainability, could result in a plunge of the Rupee and fuel cost-push inflation. We have seen a weakening of the rupee against the Euro since the start of 2018.
Domestic Dynamics
Besides external factors, domestic dynamics are picking up as well. Private consumption, Purchasing Managers’ Indices and construction activity are indicating that economic activity is accelerating.
Even loan growth is recovering from deep-red figures since non-performing loans at banks have stabilised somewhat, below 10 percent. Moreover, we expect non-performing loans to come down even further on the back of the recapitalisation operation and the increased scrutiny of the RBI to increase settlements of bad loans.
Consequently, India could close the output gap relatively fast, and most likely much faster than the International Monetary Fund is expecting.
The government stimulus announced in the Budget, such as the enhanced crop insurance scheme, will also add to rising price pressure, although the emphasis in the Budget is still on fiscal prudence.
Rate Cycles And Inflation Targeting: The Medium Term
If we look beyond the short-term inflation and rates expectations, what complicates a proper assessment of the timing of rates changes is the shift in India’s monetary regime.
It is well-known that after taper tantrum in 2013, which resulted in a sliding Rupee and persistently elevated inflation rates, the RBI decided to review its monetary policy framework and roll out flexible inflation targeting in May 2016. In August 2016, the nominal inflation target was set at 4 percent with a bandwidth of +/- 2 percent.
Estimations of a simple Taylor rule in order to explain interest rate movement in India show that results vary considerably for different periods in time, reflecting the various stages of monetary policy. During the multiple indicator-approach, the RBI policy decisions were mainly driven by growth consideration (the output gap) rather than price stability. Interestingly, when we narrow the sample to start from 2014, the period where the RBI was actively anticipating on implementing inflation targeting, a completely different picture emerges and the output gap does not have a significant effect on interest rates anymore, but inflation does have a significant and positive effect. Moreover, as inflation targeting is a brand new concept in the Indian economy, we also have to assume that the RBI will act more forcefully on rising inflation than in the past. In our models, we have estimated that the policy response of the RBI is stronger in case of breaches of the 2 percent and 6 percent bandwidth.
Within the bandwidth, the RBI will increase rates by 0.13 percentage points in case of a 1 percent increase/decrease of Consumer Price Index, whereas above or below the thresholds, the RBI will hike or cut rates by 0.77 percentage points for every 1 percent increase/decrease.
Although these effects are empirically estimated, we need more data to be sure that the effects that we have incorporates in our models reflect the way the RBI behaves. Fortunately, all economists are dealing with the same uncertainties as far as the current behavior of the RBI is concerned. Unfortunately for us, we made the wrong call on Wednesday. However, that does not mean that we have lost confidence in our fundamental view that the RBI is wary of a weak Rupee, rising capital outflows and sensitive to the risk of inflation breaching its upper band in the context of strengthening domestic activity and elevated oil prices.
Also Read: Feel-Good on India Bonds May Prove Elusive
Dr. Jekyll And Mr. Hyde
If we focus again on the short term, important inflation figures for January will be released on February 12. Right after the MPC meeting in December, inflation surged to 4.9 percent year-on-year in November and 5.2 percent in December, up from 3.6 percent in October, zooming past the 4 percent medium-term target of the RBI. Before that meeting, we were already quite pessimistic about rising inflation, but the inflation trajectory in the last two months surprised even our bearish expectations. Although incidental factors, such as unfavourable base effects and rapid price increases of certain food items, partly caused higher prices in the last two months, the inflation risks that we elaborated on in this article could result in undesirably high inflation in January. For the sake of a smooth Indian economic recovery and the RBI’s decision, the Dr. Jekyll in me sincerely hopes inflation won’t continue its steep trajectory seen in the last two months. My Mr. Hyde wouldn’t mind a further increase though…
Hugo Erken is Senior Economist at Rabobank; Country Analyst for North America, Mexico and India — RaboResearch.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.
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