RBI policy: Why a hike in rates to tame the oil shock would be a mistake

RBI has already over-achieved its inflation mandate; it needs to focus more on its growth objective

The rise in oil prices shouldn’t prompt the Reserve Bank of India to hike rates -- growth is below potential, and the government is controlling the pass-through to domestic prices. What’s more, monetary policy is relatively ineffective against cost-push inflation. Even so, the RBI has a strong -- and in our view, unwarranted – hawkish bias. Our base case remains a shift to an accommodative stance and a rate cut in December, as inflation and growth surprise on the downside.

Given what’s happening with oil prices and the RBI’s hawkish bias though, it’s prudent to consider risks to our base case scenario. One definite risk is that the RBI might respond to an expected pickup in inflation in May and June with a rate hike. In our view, that would be a policy misstep.

• Looking at the inflation trajectory, the only available window for the RBI to increase the policy rate might be a one-and-done hike in August. The RBI’s June meeting will review inflation data for March, which slowed to 4.28% from 4.44% in February; we expect it eased further in April to 4.16%. A rate hike in June, then, seems unjustifiable.

• The RBI’s August review will consider new inflation data for May and June, which we expect will increase to 4.6% -- that’s below the RBI’s own projection of an average 4.7-5.1% in 1H fiscal 2019.

• The rise in oil beyond $65 a barrel has been largely absorbed by government-owned refineries and not passed through to domestic gasoline prices. Nevertheless, second order effects from the oil shock -- 10% higher domestic gasoline prices since July last year -- could continue pushing up input prices and raise core inflation for a few more months. The divergence between the RBI’s April policy meeting that lowered inflation projections and the minutes that were hawkish suggest the argument of rising core inflation could be used to hike policy rates in August.

• Beyond June, we expect inflation to trend down to average 3.4% in 2H fiscal 2019, assuming an oil price averaging $65 a barrel. So August is likely to be a single hike, after which the data are likely to pressure the RBI back into accommodative policy.

RBI has overachieved its inflation mandate

RBI rate hike would be a policy misstep

• Monetary policy works well to temper a demand driven inflationary cycle, one in which the economy is over-heating, not cost-push inflation. The RBI seems to hold the view that a rate hike should be used to tame inflationary pressures from rising input prices on account of an adverse oil shock. In our view, such a rate hike would do more damage to growth, than contain the oil shock.

• Given the RBI has already over-achieved its inflation mandate, as reflected in the 12-month moving average inflation in the chart above, it needs to focus more on its growth objective.

• The RBI is underestimating the government’s response to the oil shock. Government-owned refineries have already capped gasoline prices. Alternately, the government can also absorb the oil shock via a cut in excise duties to head off a voter backlash from higher pump prices, especially in a pre-election year. In either case, the government takes a fiscal hit – the former results in lower dividend revenue, the latter in lower tax revenue. This will pressure the government to cut expenditure, or else risk higher bond yields. Both options will deal a blow to growth. That argues for easing, not tightening, of monetary policy.

• The current oil shock is likely temporary, not permanent, as both forwards prices and the median consensus forecast point to a drop ahead. As the shock fades away sooner or later, inflation is likely to settle permanently below the RBI’s 4% target. That would require the RBI to switch back to an accommodative cycle.

• The recent improvement in India’s growth comes off a low base and merely reflects a recovery from the twin temporary shocks of demonetization and a new indirect tax. Actual growth at 7% levels remains well below India’s potential of 8-8.5%, in our view. A rate hike will accelerate the ongoing rise in bank deposits and lending rates and impede a nascent growth recovery. This would widen the output gap and prevent the economy from achieving its full growth potential.

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Abhishek Gupta is an economist at Bloomberg India