Tough balancing act for the MPC

Even as the Monetary Policy Committee (MPC) of the RBI is completing a year since its inception, collective decision making is expected to turn more challenging given the precarious macroeconomic environment. Until the previous meeting, we had Michael Patra, Executive Director, RBI, on the one extreme, who was stressing on the need to focus on the upward trajectory of inflation going forward, and IIM-A’s Ravindra Dholakia, on the other, restating the need to boost growth through sharp rate cuts when inflation remains fairly under control.

Over the last two months, both the global and local environment have shifted gears significantly and hence it will be interesting to watch the reaction of MPC members.

Globally, oil prices are up ~10 per cent and domestic fuel prices have also increased by ~8-10 per cent. The Fed fund futures are indicating >70 per cent chance of another rate hike by the US central bank as against <30 per cent in early August. Also, balance sheet contraction by the Fed is underway albeit at a gradual pace. Additionally, there are early signs of a comeback of the reflation trades, with inflation prints across major economies surprising on the upside lately, along with DM growth firming up further providing a fillip to the emerging markets export-led growth. Rupee has consequently depreciated by 2.5 per cent since the last policy.

Meanwhile domestically, India is stuck in the low-growth and near-target inflation phase. Clearly, the lagged impact of demonetisation on few sectors along with the uncertainties associated with GST implementation has had a longer impact on growth than earlier anticipated. Until the previous policy, the RBI expected the grwoth in GVA (gross value added, or the value of all goods and services produced) to be 7.3 per cent in FY18.

While we were already quite cautious on growth (expecting FY18 GVA at 6.8 per cent), the Q1FY18 GVA at 5.6 per cent came in lower than expectations. Hence, the RBI is expected to revise down the GVA estimates considerably. While some data indicate stability over the last month, the absence of private investment, higher imports, not-so-encouraging monsoon outcome and the twin balance sheet problems are likely to continue to be a drag on growth.

Even as growth remains anaemic, the RBI’s mandate remains inflation targeting. The Consumer Price Index (CPI) inflation is on an expected upward path as adverse base effect, mean reversion of food prices and impacts of the the seventh Central Pay Commission seep in. The RBI expects inflation in the second half of FY18 to range between 3.5-4.5 per cent, as against the range of 1.5-3.5 per cent seen in most part of 1H-FY18.

Retail inflation will be inching towards 4.7 per cent by March 2018. Core inflation is getting weighed by the impact of higher GST rates on few service segments even as the underlying demand-side pressures remain muted. Further, higher commodity prices are expected to begin to pass through the Wholesale Price Index (WPI) to CPI route with a lag.

Against this perilous environment, a likely fiscal slippage can further complicate matters. Notably, the fiscal deficit until August has already hit 96.1 per cent of the budgeted numbers as the Government has frontloaded the spending. Teething issues with GST implementation (like delays in tax credits and tax filing along with technological issues) is clouding tax collections. Lower surplus transfer by the RBI to the tune of around ₹300 billion has further increased the risks of revenue slippages. With tax revenues likely to be lower than budgeted, unless non-tax receipts surprise, expenditure will need to be pruned to maintain the fiscal deficit target.

In sum, the MPC has a tough task of maintaining credibility even as it sees significant risks to growth. MPC may take a pause in the upcoming policy meeting even as there may seem a compelling case for a rate cut. With most firms operating below capacity, lower rates alone may not move the needle much unless the magnitude is large. Given the expected uptrend in inflation a large cut is unlikely.

Meanwhile, it will be interesting to see how the MPC members (especially the two extreme members) respond given the tug-o-war between the macro variables.

The writer is a senior economist with Kotak Mahindra Bank. The views are personal

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