MPC meeting: Prudent policy path need of the hour

RBI should review its currency management

The economic outlook has worsened since the August meeting of the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI). Decision making for the rate-setting committee, however, would be relatively straightforward this time as it begins the policy review today. The committee is widely expected to increase the policy repo rate. Although analysts expect it to increase the rate by 35-50 basis points, the committee would do well to opt for the upper end of the band because of a variety of reasons. A lower than 50 basis point hike at this stage would reflect reluctance on the part of the committee to take action against sustained high inflation. The inflation rate has been above the RBI’s tolerance band for eight months and is unlikely to come down quickly.

It is thus likely that the inflation rate will remain above the tolerance band for three consecutive quarters, which would be seen as a failure to attain the inflation target. Therefore, according to the law, the RBI will need to write to the Union government, explaining the reasons for the failure to achieve the target. It will also have to spell out the proposed remedial action, along with the estimated time period by which the inflation target would be achieved. Thus, against the given backdrop, it will not be appropriate for the MPC to go soft on rate action. Also, the real policy rate is still in negative territory. According to the RBI’s projection, the inflation rate will come within the tolerance band by the last quarter of this fiscal year.

Although another rate hike would affect economic recovery, policymakers would need to sacrifice some amount of growth to attain price stability in the near term. In this context, the RBI will also be expected to revise its growth projection for the year. The official estimate of growth in gross domestic product for the April-June quarter was significantly lower than the RBI’s projection. Thus, even if outcomes remain broadly in line with its projection in the remaining quarters, the full-year growth estimate of 7.2 per cent will need to be revised downwards. Given the global economic outlook, growth is unlikely to see positive surprises.

Besides the rate action and growth projection, market participants would also look for the RBI’s commentary on the ongoing turmoil in global financial markets, particularly the currency market. Although the rupee has depreciated by over 8 per cent so far this year, it has remained relatively resilient because of the central bank’s active intervention. The relative strength of the US dollar has resulted in a steep decline in other currencies, including those of advanced countries. The authorities in Japan, for instance, have intervened in the market for the first time in decades to stabilise the yen. Since the US Federal Reserve is expected to significantly tighten monetary policy in the coming months, global financial conditions are unlikely to improve in the near term. Thus, in the given situation, to what extent should the RBI support the rupee? Although foreign currency reserves are still at comfortable levels, a sustained decline will put more pressure on the rupee. Besides, the relative strength of the rupee will affect the tradable sectors at a time when global demand is under pressure. The best policy option, therefore, would be to allow the rupee to adjust in time.