A move to address looming inflation risk

The Monetary Policy Committee unanimously raised the repo rate by 25 bps — the first hike in nearly four and a half years (the last hike was in January 2014). The increase is against the backdrop of rising inflation on the back of higher crude prices, firming commodity prices, household inflation expectation of 130 bps over one-year period, stronger global economic growth and rising global interest rates.

The policy stance remained neutral while highlighting risks, both global and local, which is similar to the last policy. The key difference from the previous policy, which was more dovish, is the rise in average crude prices from $66 to $74 (India crude basket) and rising input costs.

Global, domestic indicators

Since the last policy, global growth continued to expand albeit at a slower momentum while growth in emerging markets remained resilient across the large economies. Global trade was stronger, with oil prices rising sharply and commodity prices firming up. The dollar touched its highest level in May while the 10-year US treasury crossed 3 per cent. Bond yields rose across all key emerging markets and currencies depreciated on account of a strong US dollar.

Thus, while the global growth momentum continues, the rising crude and commodity prices, strong dollar and higher yields will have its impact on emerging market currencies, yields and flows.

On the domestic front, the GDP grew 7.7 per cent in Q4 FY17-18 — the fastest growth in the last seven quarters, taking the annual GDP growth rate to 6.7 per cent. The growth has been on account of a significant increase in private consumption expenditure including improved rural demand on the back of a bumper harvest and the government’s thrust on rural housing and infrastructure.

In Q4 FY17-18, agriculture growth increased sharply, supported by an all-time high production of food grains and horticulture. The IMD’s forecast of a normal south-west monsoon rainfall augurs well for agricultural growth this year.

The manufacturing sector also showed a robust performance in Q4 FY17-18, which reflects in increased capacity utilisation and higher output. Coal production touched a 42-month peak, while cement output posted double-digit growth for the sixth consecutive month in April.

Industrial growth in Q1 of FY 18-19 is likely to be slower due to a significant rise in input prices and perceptions of softening domestic and external demand conditions.

The services sector remained robust with construction activity recording the highest growth in Q4 FY17-18. Various high frequency indicators suggest resilient performance of the services sector. Sales of tractors and two-wheelers suggest strengthening of rural demand while commercial vehicle sales accelerated in April. Passenger vehicle sales also showed good growth.

Revenue-earning freight traffic of railways picked up, driven by improved movement in coal, fertilisers, and cement. Both cement production and steel consumption showed a significant uptick.

Inflation estimates

CPI Inflation rose sharply to 4.6 per cent in April, driven mainly by a significant increase in inflation excluding food and fuel. The Reserve Bank’s survey of households reported a significant rise in households’ inflation expectations of 90 basis points (bps) and 130 bps, respectively, for three-month and one-year ahead horizons. This was one of the factors in addition to higher crude prices which led to the rate hike.

The outlook for inflation has gone up with the apex bank increasing its estimates by 30 to 40 bps over February projections. This is largely driven by higher crude prices, rise in input prices and wages, and higher momentum in the non-food and fuel inflation. Inflation is projected at 4.6 per cent in H1 FY19 and 4.7 per cent in H2 FY19.

Growth and investment

The GDP projection at 7.4 per cent in the coming year suggests a healthy growth in the economy in the coming year. With improving capacity utilisation and credit offtake, investment activity is expected to remain robust even as there has been some tightening of financing conditions in recent months. Global demand has also been buoyant, which should encourage exports and provide a further thrust to investments.

Consumption, both rural and urban, remains healthy and is expected to strengthen further.

Looking ahead

Going forward, the central bank has to contend with a host of local and global factors and their impact on the Indian economy. The RBI will continue to monitor key upside risks to inflation.

One of the key risks — higher crude prices — has played out already. Others like uncertainty in the global financial markets, rise in input and wage costs, impact of HRA increase/revisions by State governments and increase in Minimum Support Prices will be watched closely.

Further policy action will be contingent on how inflation plays out in the coming months.

The writer is President – Consumer Banking, Kotak Mahindra Bank Ltd.

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