Sustained uncertainty: RBI's MPC is unlikely to change the policy rate

Economic uncertainty has not receded significantly since the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) last met in June, and this will continue to dominate its three-day deliberations ending August 5. The fragile ceasefire between the United States (US) and Iran did not hold, and the Strait of Hormuz is blocked again, with little oil and gas flowing through this route. The strait facilitated about a fifth of the global flows of crude oil before the conflict. Signals from the Gulf are often hard to interpret. Fresh attempts are being made to open the strait, and US President Donald Trump has announced that he is holding the planned attack for now because the “perimeters of a deal” have been agreed upon. However, as long as both sides don’t firmly agree on the mechanism to address the underlying issues, West Asia will remain a source of risk for a large energy importer like India. 

The impact of higher prices of crude oil on the consumer price index has been limited due to a partial pass-through by oil companies. The inflation rate in June increased to 4.38 per cent as against 3.93 per cent in the previous month. It is not clear how long oil companies will be forced to absorb the losses. A fresh deal in West Asia will help relieve the pressure. The RBI has projected an average inflation rate of 5.1 per cent for this financial year and is unlikely to change it much at this stage. On the domestic front, the biggest risk is the possibility of lower monsoon rain owing to El Niño. Although India has ample food grains, a possibility of lower production can push up the inflation rate. A higher food-inflation rate also tends to have a larger impact on inflation expectations. The food-inflation rate increased to 5.32 per cent in June, as against 4.78 per cent in the previous month.

However, at this stage the MPC is unlikely to react to the possibility of the below normal monsoon and its impact. Given the broader economic backdrop, therefore, it makes sense for the MPC to leave the policy rate unchanged. Financial markets, however, will focus on the RBI’s commentary on both inflation and broader macroeconomic conditions. It is worth noting that the impact of higher prices of crude oil and global turmoil on India has been reflected not in inflation numbers, owing to the limited pass-through, but in the foreign-exchange market. After the June MPC meeting, the RBI announced various measures to attract foreign flows. About $41 billion has been mobilised thus far under the concessional mechanisms announced in June. Given the window is open for about another two months, the markets will want to know what the RBI’s broad expectations are in this context.

Although the inflows seem to have helped stabilise the rupee for now, it is worth noting that these funds may not solve the underlying problem. Higher inflation rates in other parts of the world, particularly in the developed world, are pushing up bond yields. Further, the communication style of the new Federal Reserve Chairman Kevin Warsh and the lack of forward guidance from the US central bank are creating a fair bit of confusion in the market. Last week, yields on 30-year US government bonds, for instance, increased to the highest level since 2007. Higher bond yields in the US and other developed countries will inevitably affect capital flows to emerging market countries like India and put pressure on the rupee. The solutions to the difficulties in the balance of payments must come from the government, which will enable the inflow of long-term, stable foreign capital into India.