Structural reforms over the last two years have boosted India’s medium-term potential growth. Now fiscal and monetary policy must strive to maintain near-term macroeconomic stability in an increasingly challenging global environment.
When the Monetary Policy Committee meets this week to decide on the course of monetary policy, it will likely be focused on projected growth-inflation dynamics in the first quarter of first half of 2019, instead of the next month or two. There are at least two reasons for this. First, a flexible-inflation targeting framework must be forward-looking, and monetary policy works with long and variable lags. So interest-rate policy at this week’s meeting will impact growth-inflation dynamics two-three quarters out. What should matter to the MPC, therefore, is where growth-inflation dynamics are likely to be in early 2019. The outturn for the next few months is already baked in the cake and, therefore, beyond the purview of policy at this point.
Second, it is widely-accepted that year-on-year headline inflation will soften in the coming months on favourable base effects, because the second half of 2017 was pushed up by the implementation of house rent allowance for government employees under the Seventh Pay Commission, and the transition to the Goods and Services Tax. Headline Consumer Price Index inflation in the second half of 2018 will, therefore, soften largely for statistical reasons. Similarly, gross domestic product growth later this year will be adversely impacted by a very unfavourable base from last year. Policymakers, and the MPC, must look through these statistical base effects.
In the case of inflation, the first uncontaminated quarter of CPI will be January-March 2019, and that is what should matter for the setting of monetary policy.
It is this logic that likely induced the MPC’s 25 basis point rate hike in June. The MPC guided that inflation in the second-half of 2018-19 (fiscal year) was pegged at 4.7 percent. Given the hugely favourable base in October-December 2018, what this really signaled was that Jan-Mar 2019 inflation was forecast to be close to 5 percent—meaningfully above the medium-term target of 4 percent—and that likely induced the rate hike. The relevant question, therefore, is what new information has been revealed since the June review to influence the MPC’s thinking on where Jan-Mar 2019 inflation is likely to be.
Core Inflation
The monthly momentum of core-core inflation (standard core adjusted for petroleum, gasoline, and housing) continues to remain elevated. In the two inflation prints since the June review, core-core momentum has averaged 0.5 percent month-on-month, seasonally adjusted (an annualised rate of 6 percent) – which is similar to the average momentum of the previous six months. Consequently, year-on-year core-core inflation printed at a three-year high of 5.6 percent in June, and core – WPI printed at a 54-month high of 4.8 percent. Two questions arise.
Second, what may be driving these core pressures? First, as research has shown, including that of one of the MPC members—Ravindra Dholakia’s—headline inflation tends to asymptote over time towards core. Therefore, elevated core inflation can be thought of as a leading indicator of headline. What’s driving core? As the Purchasing Managers’ Index surveys reveal, input cost pressures have risen in recent months, and with demand recovering and margins under pressure, these have been passed on into output prices.
The Rupee
Since the June review, the U.S. Dollar has continued to strengthen, reflecting both desynchronised growth and growing worries of a trade war. Consequently, emerging market currencies—particularly the Renminbi—have continued to weaken, with the Rupee weaker by another 2.5 percent against the U.S. Dollar, at the time of writing this.
As we have previously argued, a gradually weakening Rupee may not be undesirable from an underlying competitiveness perspective, but will have inflationary consequences that would need to be countered through monetary policy.
While it is true that, in recent months, the Rupee hasn't weakened on a nominal trade-weighted basis, weakness against the U.S. Dollar is also important given the prevalence of Dollar invoicing in India's trade. Finally, trade wars may depress growth with a lag and be disinflationary. But in the near-term, they are likely to pressure emerging market currencies and therefore be inflationary. Also, their eventual impact on global growth remains uncertain since countries are likely to use fiscal and monetary policies to mitigate any slowdown, as China appears to be doing.
Minimum Support Prices
A key inflation risk cited by the MPC at the June review was realised with the government raising agricultural support prices to correct the declining terms of trade that farmers have had to confront in recent years. An MSP increase was not previously baked into the RBI’s baseline but cited as an upside risk. With this risk having been realised, the baseline would need to be increased. Some may argue for waiting to see the impact of higher MSPs on food prices in the coming months before reacting. Remember, however, food and fuel prices have a key bearing on household inflation expectations.
If the MPC waits for food prices to go up before deciding on monetary policy, the risk is inflation expectations may have already materially hardened by then and the MPC may be left to play catch-up.
Growth
Growth has seen an impressive recovery in recent quarters even as the latest high-frequency data is emitting several cross currents. While industrial production has disappointed, the June PMI was the strongest since demonetisation. For the year as a whole, higher oil prices and bank deleveraging will pose headwinds. Yet, monetary conditions have eased in recent months as real rates have fallen and the real exchange rate has depreciated. Most expect growth to accelerate in the coming year, even though the quantum may differ. From the RBI’s perspective, therefore, what matters is that growth is currently strong enough for input prices to be passed on into output prices. That’s the key for now.
In addition, oil prices remain very sticky around the $75/barrel mark, close to where they were at the last review. This is despite efforts by some OPEC countries to boost supply, suggesting stretched underlying demand-supply dynamics. Finally, food prices are experiencing their seasonal increases, though perhaps slightly less than anticipated.
The combination of all this, however, is likely to boost the MPC’s Jan-Mar 2019 inflation forecast above 5 percent.
A Delicate Balancing Act
From a Taylor-Rule perspective, therefore, there is more confirmation that output gaps have closed (as evident in the stickiness of core inflation) and more belief that year-ahead inflation is likely to be above target, more than had been previously envisioned. This would argue for more monetary tightening.
If the RBI were to raise rates by 25 basis points at the August review—and, therefore, by 50 basis points across two meetings—the MPC would have bought itself the time and insurance needed to assess how uncertainties resolve in the coming months. Barring exceptional events, there would be no pressure to raise rates again in the coming months.
Emerging market history is replete with the same lesson: the earlier central banks act, the less they eventually need to do.
More importantly, over the last few years, India has been widely regarded as a relative safe-haven in the emerging market universe because of its improved fundamentals and because it has been seen to put a premium on macroeconomic stability. Being seen to act when inflation is forecast to be above target would only buttress those credentials, in this increasingly challenging global environment.
We don’t believe, however, there is necessarily a case for the RBI to change its stance just yet. A stance change should hinge on how many hikes the MPC foresees in the pipeline.
Only if the RBI believes it has much work to do in this cycle—which is not our base case—will a stance change be warranted.
Structural reforms over the last two years have boosted India’s medium-term potential growth. Now fiscal and monetary policy must strive to maintain near-term macroeconomic stability, against an increasingly challenging global backdrop. The August RBI policy must be viewed in this larger context.
Sajjid Z Chinoy is Chief India Economist at JPMorgan.
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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