Monetary policy: Where to from here?

The Reserve Bank of India policy committee’s double surprise in February — unchanged policy rates and shift in stance to a neutral bias from an accommodative one — pulled the brakes on the easing cycle that started in early 2015.

This has raised questions over the future course for policy rates. A few market participants are still holding out for rate cuts. We, however, are of the view that the monetary policy will be held steady in April and for the rest of the year. Beyond this, the next move is more likely to be a hike rather than a cut.

Inflation is the primary mandate of the central bank and hence of most importance. Interestingly, India’s wholesale and retail inflation gauges are running at different speeds. In a break with tradition, headline WPI is no longer below, it stayed above the rebased CPI series at the end of 2016.

Since last November, WPI inflation has risen above 4 per cent while CPI inflation fell below the same level. Digging deeper, the main reason for this divergence is the composition of their inflation baskets. The drivers are also supply-oriented rather than demand-led.

Impact of global movement The weightage of tradables in the WPI basket is high (40 per cent), making the index more vulnerable to movements in global commodity prices. Since the previous quarter, two-thirds of the surge in the WPI inflation has been due to higher prices of fuel, metals, minerals, etc. Removal in fuel subsidies and unfavourable base effects will see WPI inflation gain further ground in the first half of this year. In contrast, tradables account for less than 20 per cent of the CPI basket.

On the other hand, the food component has had the opposite effect on CPI inflation. Food makes up more than 40 per cent of the CPI basket, but less than a quarter under WPI. And this component fell sharply from the highs of 7.5 per cent in mid-2016. The sharp downturn in perishables particularly in early 2017 was driven mainly by demonetisation, apart from end-year seasonality.

These factors reinforce our view that supply factors rather than demand was the main trigger for the diverging trends.

Now to the crucial question: Where to from here? Clearly CPI trends will be more important than WPI as the former is the monetary policy target.

It should be noted that pipeline risks for retail inflation are likely to build as the jump in WPI input prices begins to feed into output prices with manufacturers looking to preserve margins. The positive correlation between CPI and WPI trends (barring the most recent divergence) is also another factor to watch.

Since fuel and other commodity prices will stay beholden to the global environment, the main factor to watch is food prices. In recent years, cyclical factors including a smaller increase in the minimum support prices, timely rains, lower rural wages and a negative output gap have helped keep food inflation below 5 per cent in 2015-2016, down from double digits in 2012-2013. This has helped the RBI successfully meet its inflation targets in the last two years.

Future prospects Looking ahead, to meet and maintain the 4.0 per cent medium-term CPI target next fiscal, the contribution from food inflation has to fall sharply by another 150 bps from the previous year, that is, from over 2.0 percentage points this fiscal to 0.7 ppt next year.

This is a tall order in the midst of fading impact of the banknote ban, uncertainty over this year’s monsoon, higher minimum support prices for selected groups and improving rural wages.

We expect food inflation to firm up next year and prop the headline CPI inflation to 5 per cent from this year’s estimated 4.6 per cent. Apart from food, the other routinely sticky components, especially those with supply gaps — health and education — are likely to contribute to inflation.

The core gauge has already reacted a little to last year’s disinflationary pressures. Notably, the inflation targeting regime of the central bank is flexible, hence limiting risks of premature tightening. Nonetheless, the next move beyond this year’s status quo is likely to be a hike rather than further cuts.

Besides inflation, the RBI is also likely to keep an eye on liquidity conditions. Liquidity is flush in the wake of demonetisation and strong portfolio inflows. The banknote ban led to a surge in deposits and subsequently a sharp increase in the banking system’s liquidity. Concurrently, foreign portfolio investors are also back after sizeable outflows in 4Q16. Domestic mutual funds also invested strongly in early 2017, before profit-taking set in March. To rein in part of this cash surplus, the RBI undertook directed measures (incremental cash reserve ratio and market stabilisation bonds) late last year.

The recent move to restore cash withdrawal limits and seasonal tax outflows in March also likely impinged on the cash pile-up. Despite these forces, excess liquidity is still to the tune of ₹4 trillion, much more than the neutral balance the RBI is comfortable with.

The implications This has two implications. Firstly, the central bank has become wary of intervening actively with the rupee’s slow ascent (apart from providing an ad hoc presence), for fear of stoking liquidity further. The rupee has therefore rallied nearly 4 per cent this year, emerging as one of the best performers in the region.

Secondly, flush liquidity also gives rise to inflationary concerns, posing a risk to the central bank’s price stability mandate.

More action is likely to rein in this excess liquidity. There are indications that a new standing deposit facility is under consideration to mop up some of this surplus, but without any implications for monetary policy.

This will help lower the costs of cash absorption, whilst keeping the longer-end rates anchored. It remains to be seen how expeditiously this tool is introduced since changes to the RBI Act are required as a precursor. In the midst of this, the odds of an aggressive move like a hike in the Cash Reserve Ratio are down sharply.

Finally, keep an eye on global developments, especially the direction of US Fed policy. Further compression in the US and Indian long-term rates, coupled with the dollar strength could induce volatility in the financial markets.

Stability will be a priority for the RBI, prompting a status quo stance on rates. In all, given these risks to the outlook, the path of least resistance for the RBI policy committee is to maintain rates on hold this year.

The writer is an economist with DBS Bank, Singapore

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