Cause for a pause: RBI has to weigh inflation, fiscal deficit, bond yields

Risks of the govt overspending in 2018-19 are substantial; RBI will certainly have to change its own calculations about monetary policy

As the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) sits down to consider India’s monetary stance on Tuesday, it will have multiple stress points to consider. The recently presented Union Budget for 2018-19 saw the government compromise on its path of fiscal consolidation. The fiscal deficit for the ongoing financial year is estimated to come in at 3.5 per cent of gross domestic product, or GDP, a revision from the target in last year’s Budget of 3.2 per cent of GDP; and the fiscal deficit for next financial year is projected as being 3.3 per cent of GDP, instead of the earlier 3 per cent outlined by the fiscal consolidation path. This excess spending will certainly have to change the RBI’s own calculations about monetary policy. The risks of the government overspending in 2018-19 are substantial. Even if the forthcoming general elections are taken out of the equation, the future path of crude oil prices, and therefore of fuel taxes and fertiliser subsidies, is uncertain. The new government health care insurance promise is not properly budgeted for, and disinvestment receipts are always hard to predict. In addition, while an increase in the food subsidy has been worked into the Budget arithmetic, the size of the minimum support price increase, targeted at farmers, is yet to be known. 

The bond markets have already noted this problem. India’s yield curve has steepened sharply over the past few months, and the response to the Budget was also negative for 10-year government securities, or g-secs, of which the current yield is around 7.6 per cent. In other words, bond yields are considerably higher than the headline interest rate of 6 per cent, which was last changed in August 2017, when it was cut from 6.25 per cent. This is not sustainable for very long. Last Thursday, the RBI called off a Rs 11,000-crore auction for fear of further provoking the bond market — the fourth such action in a month. The deputy governor of the RBI, Viral Acharya, has already rightly pointed out that the central bank cannot make a habit of assisting banks that are making a loss on their portfolio, which has depressed demand in these auctions from public sector banks. Nor are the inflation dynamics comfortable for the RBI. In December, consumer price inflation came in at a 17-month high. It is not in the danger zone yet — the RBI targets a consumer inflation rate of 4 per cent — but the upward movement suggests caution. Meanwhile, growth considerations have receded from the horizon, as demand appears to be returning to the economy and the slowdown that began in early 2016 seems to have bottomed out. 

On balance, there is good reason to expect that a rational balancing of danger on either side should suggest to the MPC that it look for an opportunity to raise rates and restore stability to the debt market, and reflect the government’s changed fiscal stance. However, it may be too early to make this call, as the effects of the Budget are still playing out. The RBI should hold rates at this meeting, but change its language about the path of future hikes accordingly.