Case for a pause

RBI should hold rates, but address tight liquidity

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) is due to meet in the first week of December, and expectations from the government to cut the policy interest rate, currently at six per cent, continue to be high. The government’s argument is simple. In its last statement after its October meeting, the MPC had highlighted some actions it expected the government to take, including moving forward on the insolvency process and cleaning up the implementation of the goods and services tax, or GST. On both these fronts, there has been a reasonable amount of action since October. Partly as a result, the moderate growth momentum has been restored to the economy and may be sustained for some time. In the data released last week, the Central Statistics Office of the government indicated that growth in the second quarter of the financial year 2017-18 had reversed the falling trend exhibited by the previous five quarters. Year-on-year growth in gross domestic product, or GDP, came in at 6.3 per cent. For the MPC, this may well be a sign that the urgency of cutting rates to reverse the growth slowdown is no longer that pressing, and the government’s case for a cut is thereby weakened.

The RBI’s concerns at its last meeting about inflationary pressures continue to be relevant. Consumer price inflation in October came in at around 3.6 per cent, the highest for several months — driven in particular by food inflation, which has a disproportionate effect on expectations. While this is still comfortably within the RBI’s target zone for consumer inflation, the upward momentum of inflation will worry the MPC. In fact, it is likely that the four per cent mark will be breached by an inflation print sometime in the coming months. Questions about the trajectory of oil prices are particularly relevant here. It is clear that the production cuts by the oil-producing countries’ cartel, OPEC, have had an effect on prices. In October, the RBI held steady with a lower inflation print and with weakening economic growth. It can hardly retain its credibility if it then cuts rates following a higher inflation print and just after the data emerges suggesting growth has bottomed out.

However, there are other considerations that the MPC should take into account, and other instruments that it must examine besides the headline policy rate. For one, the market has concerns that liquidity has become tighter than is comfortable, given that the RBI has conducted a sterilisation exercise even as the government builds up a heavy cash pile awaiting the dispensation of the input tax credit for the GST. Tight liquidity has created upward pressure on short-term rates. The MPC will have to balance this pressure against the possibility that a tranche of treasury bonds issued under the market stabilisation scheme following demonetisation will mature and thereby add to liquidity. If a recovery in growth causes credit growth also to increase, then the RBI’s liquidity management will be additionally complicated. While interest rates should be held steady in December, the MPC’s actions on liquidity will be closely watched.