RBI policy review: MPC surprises but stance indicates future hikes

The decision underlines a strict adherence to its inflation mandate to the exclusion of all other considerations such as exchange rate and financial stability

The Monetary Policy Committee (MPC) sprang a surprise by keeping the repo rate unchanged even as it changed its stance to “calibrated tightening”.  In justification of the rate decision the committee lowered its inflation projection for rest of the year as well as for Q1FY20.  The growth projections were left unchanged.

The decision on Friday underlines a strict adherence to its inflation mandate to the exclusion of all other considerations such as exchange rate and financial stability.  While this is in line with its legislative mandate, it also flies in face of evolution of thinking on central banks.

Globally the lustre of inflation targeting has waned and “barebones” central banks are out of fashion. The 2008 crisis showed the importance of financial stability and also the indispensability of central banks in defusing the crisis. In part the crisis was also blamed on developed market (DM) central banks’ excessive focus on inflation mandates and myopia towards risks building up in credit and asset markets.  

For emerging market (EM) central banks, it’s always been a given that they have to assume a wider responsibility rather than a narrow focus on inflation.  

In particular managing exchange rate is a task that EM central banks cannot wish away.  Case in point being central banks of other CAD countries (e.g., Indonesia, Philippines) acting on interest rates with currency movements in mind.  By explicitly refusing to let currency dictate its monetary action the MPC and the Reserve Bank of India (RBI) now stand out among EM central banks. Coupled with the relatively lighter intervention in the forex market in Q2, this also hints at some divergence between the RBI and government in terms of handling the exchange rate.

Be that as it may, on its own merits also, the committee’s decision to pause is questionable.  I think the MPC is underestimating inflation risks from crude and the rupee, and overstating the sustainability of recent undershoot in food inflation.  In FY20 the RBI expects headline inflation to be in the 4.5-4.8 per cent band, compared to my expectation of consumer price index averaging 5.3 per cent in that period.

Thus the RBI and the MPC seem to be giving lot of importance to current inflation readings instead of risks to the base case.  In an environment where growth is strong, output gap has closed and government policies are geared towards pushing up farmer incomes, the committee’s judgement seems risky.  

It is plausible that the MPC is worried about growth outcomes due to recent developments in the credit markets; however such concerns do not find expression in their growth forecasts. In any case the backdrop of solid US growth, rising bond yields and strong dollar also argues for a more cautious approach from the MPC. To sum up, in line with my inflation projections and the changed stance, I expect a minimum of another 50 bps hike in the repo rate before the MPC can pause for any meaningful period of time.

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The writer is head, fixed-income research, ICICI Securities PD