RBI Monetary Policy: Here’s what economists are expecting

The Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) will meet to discuss if the policy rate needs to be hiked. The MPC hiked rates last time around and since then an aggressive minimum support price program has been announced, core inflation has jumped, food inflation has dramatically slowed and externally the yuan threatens to weaken.

Samiran Chakrabarty of Citibank, Sajjid Chinoy of JP Morgan, Soumyo Kanti Ghosh of State Bank of India (SBI), Sonal Varma of Nomura and Pronab Sen discussed what the official MPC ought to do on August 1.

Varma: The minimum support price (MSP) announcement that the government has – now that is clearly known, the main question is whether MSPs become effective. While there are three procurement options that are being contemplated to make MSPs effective across all crops. The challenge for FY19 is basically implementing this across all states, across all crops because there is a lot of infrastructure backing that is required. I think the overall impact of MSP on inflation without an effective procurement across all crops is closer to 20-30 basis points (bps). Of course if procurement happens and they make it effective across all crops then the impact in our view could be 70-90 bps but we don’t think that will show up in FY19. So the bigger driver as far as the decision is concerned is not so much the MSP but the core inflation and the build-up in core momentum that we have seen, which is clearly quite significant.

Sen: If you recall, the last MPC meeting was dominated by MSP and oil prices. Now we have a certain amount of certainty in both. So there is nothing to speculate about except the extent to which the MSP is going to be effective. The real question that is going to face the MPC is core and the reason why core is going up, nobody knows -- Soumyo Kanti Ghosh has very nice paper where he discusses the components for the acceleration in the core but it only provides a pointer rather than an explanation and until we really have an explanation as to what is going on because if you look at his paper, he says it’s essentially been driven by services which leads to a very substantial question which is this whole business of linking inflation with the output gap doesn’t seem to be working terribly well on there unless you are defining services in a particular manner. So I think the MPC has a real challenge in front of it which is – 1) diagnosis of why core inflation is going up and to date I haven’t seen anything worthwhile on the subject and 2) what do you do about it. The point is since the core is going up and given the mandate of the MPC, I have a feeling that there is only one way that they are going to chopped.

Ghosh: I would be dishonest if I say it is not worrying enough. Yes, it is worrying enough. It is running at more than 6 percent. The last was 6.3 percent but if we actually dissect the core inflation and the number from when it started to go upwards from July ’17 till June 2018. I think the worst is behind us. If you look into the core inflation weighted contribution to the overall headline inflation, you will find that housing and the transport segment has contributed around 60 percentage of the increase in the core inflation. Yes, there is increase in health education, basis percentage point increase education is there but the increase in health and education combines around 18-19 bps. So there is an element of service component in it but I think a large part of it is also driven by the transportation component which is the oil part and the housing component and my sense is that the housing component contribution which is around 37-38 bps which is now very close to 40 bps which was estimated by the MPC and other market estimates which is very close to that and it has peaked out and also if you look into the momentum of the core inflation. It is now slowing down. On seasonally adjusted basis and also on a month-on-month basis if you just look into the data, it has slowed down and our estimate suggests that possibly towards the end of March ‘2018 because now we have a very favourable base effect. If you look into the pure base effect, the number is going to hit below 5 percent by March 2018. So the point is that we need to now look into wait and watch data because now the MSP factor will come into play and let me mention a small point here, after the MSP prices, we looked into market prices and MSP. The market prices still significantly lower than MSP but for four crops, for example bajra, maize, groundnut and Sesamum, there is a 15-20 percent increase in the market prices which contributes around 7-8 bps of the headline consumer price index (CPI) number. So my sense is that two months of wait, you will get a clear idea because there is a possibility of an increase in the market prices even though they are significantly deepest as of now and after two months once you get a clear picture then more of core inflation will be better because oil prices now also stabilizing, so stripping out the oil, you can then have a fair idea of the core movement.

Chinoy: I worry very much about core inflation. First let’s agree on how we define it and Soumyo is right, we should take out petrol and diesel, take out housing and get to what I call core core inflation. Just look at the momentum of that over the last eight months, core core inflation has averaged almost 0.5 percent on average over the last eight months. What is the new information we have since the last policy review? May core inflation got revised the momentum from 0.5 to 0.6. June momentum on the back of that elevated number was 0.4, right – that is still very elevated. So we are sitting in June, looking at core inflation core core adjusted for these components running at 5.6 percent. This is not one or two months; this is now happening for eight months. So something is going on where inflation has become much more generalized. Why is it happening? In my view two-three things. One, if you look at rural wages, in the last three-four months carefully adjusted. The month-on-month momentum has gone up. We know the government would like to refit the rural economy. Two, output gaps have closed, growth has been quite strong. Three, we are seeing the lagged effect of some pick up in oil prices which may have stabilized. Four, the rupee. We found in previous empirical work, there is a reasonable pass-through from the rupee to core inflation. So there are enough worrying factors to suggest the momentum may not stop just as yet.

I will just make two final points. What is new compared to the last review. One, core inflation remains elevated. Second, the MSP risk has been realized. Three, we could have more emerging market currency weakness for two reasons – 1) dollar strengthening because the global economy has become much more desynchronized, US growth in the second quarter is 4.4 percent, Europe has slowed and the CNY (China Renminbi) is depreciating. So we could see more rupee weakness going forward which is what India cannot afford to avoid given the real appreciation – that need to be counter through. My last point is let the framework be the same. One year ahead where is inflation; the RBI said 1Q ‘19 will be 5 percent in the last review or thereabout. Now with the MSP risk being realized that 1Q ‘19 will be above 5 percent which in my view will be enough for them to worry.

Chakrabarty: Fisc has been a worry for the central bank for some time now. In our view for the full year it is a bit early, premature to talk about fiscal slippage but if you look at the state finances report from RBI. It clearly articulates that the slippage on the state finance side has been quite systematic over the last few years. So much so that the farm loan waivers are almost becoming equal to the whole Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) payments for the full year and that is something which would be adding on to demand pressure. So from overall demand side perspective the fisc is a worry but in August, right in the beginning of the fiscal year, it is a bit too much for the MPC to take a call on how much slippage would be there and to what extent that will get transmitted into an inflation impulse.

Sen: That is difficult to say. There are two contradictory forces in operation. The first of course is that I think the banking sector is starting to come out of the funk it has been in a while. So that is a plus. The minus is that trade wars now look very much more likely which means that the external effect is going to be far weaker than one had hoped. So it’s little difficult to say but I would moderate my growth expectations at this moment.

Chakrabarty: If you look at last half of FY18 and early part of FY19, we are coming off a low base of demonetisation and goods and services tax (GST) related disruptions. In fact, the July-September quarter in some sense will probably be the first clean quarter without these base effects and we need to see how the growth numbers hold up for this quarter. Our sense is that at the 7.7 that we have seen is probably closed to the peak for FY19. So from here on, we would see some moderation in growth numbers. I am not for a second suggesting that it is still not a substantially robust growth, it is still a substantially robust growth particularly in the context of what Dr Sen mentioned about the global dynamics even if we get somewhere between 7 and 7.5, in my view, that is a very good number to have but sequentially it will appear to be somewhat of a slowing down.

Chakrabarty: The MPC always worries about it but incrementally between June and August, I do not think we have heard enough information on growth which would change the stance on growth materially between June and August.

Ghosh: I believe that the external sector is actually a matter of concern because if you look into US-China trade war and as Sajjid was saying US is possibly going to hit a growth of 4 percent. The European Central Bank (ECB) could actually end tightening towards the end of this year but you have to also juxtapose the factor that the wages are actually been significantly deepest in US and across the world for the last couple of years for various reasons but in Japan if you look at the experience of Japan; the inflation target could actually be lowered by 1 percentage point in 2019 than what it was earlier projected and also an interesting development in China; in last one month the yuan has depreciated by close to 4.5 percent against the US dollar and there are reports in the market that the Chinese central bank may possibly want yuan to gradually depreciate because there has been talks of currency manipulation. So they want the currency to depreciate but the flip side of that is if that happens then that will drag the entire region’s export growth rate downwards and in that case the central banks like Indonesia which were hiking the rates, could not possibly do that till 2019 till the trade war resolved. So that is a serious issue which we need to look into.

For us, the domestic factors if you look into, the credit growth rate has picked up in some of the sectors like commercial vehicles where replacement demand is strong, tyres also is one of the segments, cement is one of the segments but I think our broad based recovery is still far away and if I juxtapose the external sector factors into account, I think the US possibly is also veering towards a less of aggressive rate hikes in 2019 even though September rate hike could be a possibility. So taking all these factors on the table, my sense is that exports are unlikely to push up domestic growth to a significant extent and domestic demand as of now doesn’t look entirely promising.

Chinoy: I do not think the MPC should keep changing the goalpost because the yields have moved up or down, we should not stick to our mandate because by that logic they shouldn’t have cut rates last June or hiked earlier this year. I think on the liquidity front, the policy is quiet clear that durable outflows in liquidity will be met by durable injections. What is notable is between January and June currency in circulation has been surging, growing at 40 percent over last year for a variety of different reasons. If that pace continues and given the pace of BOP intervention we have seen, you may require anywhere from 2 trillion of base money to be injected in this fiscal year. If the RBI is selling dollars to prevent more depreciation the only way to inject is through open market operations and that is why you have begun to see the systematic plan where every month there is one open market operation (OMO) being done. I think if currency in circulation continues at this pace, the pace of OMOs in the second half of the year have to increase to meet those liquidity requirements which from the bond market’s perspective provide some relief. So the tug of war will be on the one hand, borrowing in the second half is higher. You could have some fiscal slippage on the state perspective but offset a bit by the OMOs, the RBI will need to do to stick to its liquidity policy of keeping liquidity close to neutral.

Chinoy: Close to neutral.

Chakrabarty: While we are saying that second half central government borrowing will be higher, we have to keep in mind that the state government borrowing in the first half is higher year over year by 25 percent. So to that extent if the states do not slip much on the fiscal, the second half borrowing requirement for states could be a tad lower, balancing out the central government’s higher borrowing. So it’s a bit planned here that to push more state borrowing in the first half and have lesser state borrowing in the second half.

Varma: I think markets were more contemplating a change on stance potentially at the June policy meeting. There is no expectation, I would say, for a change in stance in August. So if it happens that will be a big negative surprise. If the MPC does deliver another hike in August then it would have been 50 bps cumulative hike. I think at the margin there has been tightening of financial conditions in the last nine months and the global growth outlook is also turning more negative at the margin. So the current growth numbers may not sustain over the next 12 months and that itself might mean some moderation in core inflation. So with the hikes that we think will get delivered - should be sufficient for MPC to wait and watch to see how things pan out. So there is no need for a change in stance at this stage now.

Sen: As far as the MPC is concerned, I believe a lot of what we have discussed already got factored in in the last policy. The question now is that do they need to do anything further and if so why. So far I do not think there is really any compelling reason why anything has to be done further at the stage. There are too many imponderables particularly on the global front. I think Sajjid is right, the only thing that is fairly clear is that the dollar will strengthen, all currencies are going to be weaker relative to the dollar but the real question is what is going to be the relative price of currencies other than the dollar and that is going to be the big question because with the kind of trade wars that looming ahead of us, the competition for alternate market is going to become much more aggressive and that is going to be something that certain countries; China almost certainly are going to be doing aggressively and deliberately. Our stance has always been that we do not tinker with the exchange rates but in which case you have to figure out what you do in terms of your other macro policies because that is going to be the big challenge ahead of them.

Varma: Hike by 25 bps.

Ghosh: Pause.

Chakrabarty: Pause.

Chinoy: Hike by 25 bps.

Sen: Hold.

Varma: We are expecting a hike in August and then pause from the MPC.

Chakrabarty: Expect one 25 bps hike but not in August.

Ghosh: Maybe one.

Chinoy: Two hikes for this fiscal year including August.

Sen: One.