A healthy debate: The case for and against interest rate hike

Having raised policy rates to about 6 per cent, does India's Monetary Policy Committee need to do more? And, if so, is more front-loading warranted?

Confronted with the trifecta of a surging US dollar, elevated global commodity prices and the most aggressive and synchronised global monetary tightening cycle in 40 years, India’s Monetary Policy Committee (MPC) has put its head down since April and done what needed to be done: Re-prioritising inflation and gradually calibrating India’s monetary settings to a post-pandemic world.

But having taken effective policy rates from 3.35 per cent to about 6 per cent, the MPC is now witnessing a healthy debate: Does more need to be done? Has enough been front-loaded? One school of thought within the Committee is to now adopt a “wait and watch” approach. Why?

• First, monetary policy works with long and variable lags. The impact of the extant normalisation will only be seen in the coming quarters, and with the global economy expected to slow, some disinflation is inevitable. Furthermore, it’s important forward-looking real policy rates don’t overshoot, given the growth outlook.

• A second rationale put forward is that, under India’s inflation targeting framework, monetary policy must focus only on domestic growth-inflation dynamics and not on external considerations. Other instruments can be used to manage the external sector.

Both are important arguments and need to be carefully evaluated. How should one think through them?

First, monetary policy must undoubtedly be forward-looking. But given the unprecedented uncertainty we are currently experiencing, horizons matter. Inflation forecasts that are much into the future will inevitably contain much larger bands of errors and therefore may have more limited value. For example, the Reserve Bank of India (RBI) expects inflation to average 5.2 per cent in FY24, but that is so far out that policy today can’t be taking those outcomes for granted just yet. Instead, more weight should be given to the coming quarters about which more is known. While the RBI expects inflation, helped by favourable base effects, to gap down to about 5.8 per cent by the first quarter of next year , an uneven monsoon and a weaker rupee (needed for external re-balancing, as we discuss below) create meaningful upside risks, and we expect headline consumer price index to average discernibly above 6 per cent till the end of this fiscal year. With inflation having averaged over 6 per cent for the last 30 months, monetary policy will therefore have to remain vigilant until there is more conviction of a sustained disinflation.

Illustration: Binay Sinha

A second case for remaining vigilant is the nature of underlying pressures. Inflation is not just being driven by a few idiosyncratic items. Instead, underlying measures of inflation (trimmed mean, diffusion index) suggest price pressures remain broad-based. This was reinforced when the annualised monthly momentum of core prices picked back up to 6 per cent in September. This breadth also likely explains why both household and business inflation expectations, which had accelerated over the last two years and then encouragingly begun to soften, have picked back up again. With expectations adaptive, the longer inflation festers, the greater the risk expectations harden further.

Third, even as real rates may have become positive from a forward-looking perspective, it’s not clear they are excessive. For example, if the RBI were to take policy rates to what markets are currently expecting (6.7 per cent) and inflation pans out in line with the RBI’s FY24 forecast (5.2 per cent), this would still imply a forward-looking real rate of 1.5 per cent. Recall, however, keeping inflation close to the 4 per cent target in the five years prior to the pandemic necessitated a real policy rate of 2.5 per cent. Have neutral rates fallen since then? Will 1.5 per cent be above neutral? Possibly. But if the objective is to continue disinflating — first getting inflation below 6 per cent and then gradually towards 4 per cent— real rates may temporarily have to go into restrictive territory. Admittedly, given the unprecedented confluence of shocks, it’s not clear if the old rules of thumb apply. So the RBI will have to cross the river by feeling the stones and calibrate policy consistent with a sustained disinflation. It’s not clear if we are there just as yet.
 

What about the argument that monetary policy should not pay heed to external factors? To be sure, the spirit of the flexible inflation targeting framework is that of separability, wherein interest rates and liquidity management are directed towards “internal balance” (domestic growth and inflation) whereas other instruments (FX intervention, exchange rate, capital flow measures) can be used to achieve “external balance”.

But it’s important to appreciate internal and external balance are not mutually exclusive, and there are crucial feedback loops between the two. For example, like other emerging markets, India’s balance of payments has been under pressure, in part, because the current account deficit (CAD) has widened sharply and will need to be reined-in to more sustainable levels. This can be achieved in two ways: Tempering demand through tighter monetary and fiscal policy (expenditure compression) or letting the exchange rate adjust to boost exports and discourage non-oil, non-gold imports (expenditure switching). But remember, a weaker exchange rate will push up domestic inflation to which monetary policy will have to react.

More fundamentally, if one holds the fiscal path constant for the moment, policy rates and exchange rates simultaneously become both substitutes and complements. If policy rates are not tightened sufficiently to rein in the CAD, the exchange rate has to do the heavy lifting. But that, in turn, will result in greater domestic inflation to which monetary policy will have to eventually react. In other words, monetary policy will either have to tighten “ex-ante” (to temper demand, reduce the CAD and take some of the pressure off the currency) or “ex-post” (to react to the inflation generated by the exchange rate adjustment needed to narrow the CAD). 

To be sure, FX reserves can be used to mitigate the trade-off. But a non-trivial quantum of FX reserves has already been used and reserves will need to be managed under the presumption that the shock lingers on. Furthermore, reserves should not be used to prevent the fundamental real exchange rate depreciation that is necessary in response to the sustained terms of trade shock that the economy is confronting. In practice, all three instruments — FX reserves drawdown, exchange rate depreciation and monetary normalisation — will need to absorb some part of the pressure.

All told, therefore, even if one is agnostic about the impact of global interest rate differentials on India’s capital account, monetary policy cannot ignore the external sector because of the current account and its impact on inflation through the rupee. Therefore, even a puritanical interpretation of the inflation targeting framework will have to incorporate external developments.

Policymakers must receive a lot of credit for protecting financial stability during the pandemic and building up a war chest of FX reserves. Now we must take the preservation of macroeconomic stability —containing both external and internal imbalances — to its logical conclusion. In this unforgiving global climate, it is preferable to make a Type I error (doing too much) because it can be quickly and easily reversed. But making a Type II error (doing too little) can result in pressures to macro-stability and a hardening of inflation expectations, whose consequences can linger for much longer.

Will there be some cost to growth?  Emerging markets will have to face the uncomfortable reality that there is often a short-term trade-off between growth and macro-stability. The redeeming factor: There is no such medium-term trade-off. Macroeconomic stability lays the foundation on which medium-term growth prospers.

Postscript: The idea of moving to a MPC back in 2016 was the belief that the discussion and debate that such a system engendered will lead to an improved quality of decision-making. The robust and high-quality debate that we are witnessing in the MPC is a sign of how that institution is maturing and therefore a process that should be cherished, in our view.

The writer is chief India economist at JP Morgan. All views are personal