Risk-Reward Trade-Off Favours a Hawkish Hold by RBI MPC

The upcoming RBI MPC decision is getting billed as a stress test of the flexible inflation target regime.  Sharp weakness in the rupee hangs over as a dark cloud over the decision, even as inflation pressures, as proxied by CPI, have stayed benign so far and argue against any rate hike action. 

Typically, Emerging Market central banks use a mix of tools, including forex intervention operations and macroprudential measures, to deal with sharp depreciation pressures in the currency.  The bias is to resist an interest rate defence if inflation is soft, to curb the growth sacrifice.  In practice, a mixed response is typical.  That is also clear from the recent policy decisions from other central banks in the region, such as from Bank Indonesia, which surprised with a 50bps hike and simultaneously announced other steps to augment capital inflows.  Bank of Korea also delivered a hawkish hold, with their own version of a ‘dot plot’ indicating rate hikes in the six-month forecast horizon. 

To be sure, India’s circumstances are different, but not entirely in a good way. 

The rupee has remained under pressure even before the energy shock struck at the end of February.  And India is considered more exposed to the latest tremor also.  In this backdrop, will it be suitable from a monetary policy standpoint to attach large weight to realised inflation that is still soft, and to dismiss the energy shock as a supply-side one? 

Also, will a status quo policy be consistent with the RBI Governor emphasising a ‘whatever it takes’ approach to tackling rupee volatility? It appears the preference is to wait for second-order effects on inflation to manifest, and that is a natural starting preference for any central bank.  However, given the already weak sentiment on the rupee, there is a case for the RBI MPC to be extra vigilant to curb the risk of falling behind the curve in tightening policy (if that is required). 

Such a mistake can be costly, as markets will then move to price in more aggressive tightening and a higher terminal policy rate.  RBI’s own reaction function in the past indicates little scope for dismissing bouts of rising energy prices as a one-off driver of inflation, with a monetary policy response typically required.

No Immunity
While a low starting point for inflation provides a buffer, it doesn’t give immunity. 

Specifically, there are a few reasons for concern about the inflation outlook. 

• One, there is no Iran-US deal yet, and resultant depletion of global crude inventories portends a higher floor for crude prices.  In fact, prices could drift higher again if flows through the Strait of Hormuz are freed up slowly only. 
• Two, domestic retail prices for petrol and diesel have gone up substantially, and that would impact inflation expectations. 
• Three, simultaneous shock to food inflation from El Niño conditions is an additional concern, more so with the starting point of low prices.  Simultaneous shocks to food and fuel inflation is a potent mix and could spill into core inflation. 
• Four, risk of wider pass-through on inflation is higher when growth is strong, and recent high-frequency activity data indicates resilience.  Not just domestic consumption data, but even external sector data such as non- oil goods exports, as well as services exports, have stayed strong. 
• And finally, WPI inflation has picked up sharply already and threatens to spill over. 

To be sure, historically, the pass-through to retail inflation has not been uniform.  For instance, pick-up in WPI inflation in 2022 didn’t shift the core CPI inflation profile.  But note that core CPI inflation was already high to begin with at that time, in the vicinity of 6%.  Also, rupee weakness over the last 15 months could be an additional catalyst for higher inflation this time.

Above Neutral
Given the above, there is a good probability that headline inflation could average close to 5% in the current fiscal, and inflation in the back half of the fiscal may be even higher.  There is a case to expect a similar inflation profile in the next fiscal year also, if growth holds up, and that is the base case. 

A simple Taylor rule framework could provide indicative colour about suitable policy settings in this macro context. 

An inflation-targeting central bank normally responds more than proportionately to an inflation overshoot, so that real policy rates rise when inflation pressures build. Above neutral monetary policy settings ultimately stem the inflation rise.  Even with a conservative assumption that equal weight is assigned to the inflation and output gaps, the implied setting would call for a real policy rate to be close to neutral levels at least, of ~1%. On this arithmetic, the repo rate may eventually need to settle in the 6–6.5% range over the next few quarters.  On nominal basis also, that range will be consistent with the long period average for repo rate.

To be sure, monetary conditions have already tightened beyond what the current repo rate indicates. Money-market rates have moved sharply higher, with three-month certificate of deposit rates recently trading around 7.8%, while foreign exchange markets are also pricing in tighter conditions, with one-year forward implied yields pointing to an effective policy rate closer to 6.8%. In that sense, part of the adjustment that would ordinarily be delivered through policy rates has already occurred through market pricing.  That provides RBI some degrees of freedom to wait before it is forced to pull the trigger on rate hike.

This may be one reason also for the RBI to maintain benign liquidity conditions, even as the tone of the monetary policy needs to drift to the more hawkish end of the spectrum in the upcoming policy meeting.  The cost of such a tone shift is minimal given prevailing market conditions, and it curbs risk market feels RBI will fall behind the curve in case global conditions stay unforgiving by the time of the August MPC meeting, and/or inflation surprises higher. 

It is consistent for the RBI to signal lower bar for some policy normalisation also if emergency measures are on the anvil to manage the rupee, given the linkages between market segments.  RBI’s flexible inflation targeting framework shouldn’t make it blindsided to challenges of monetary policy making in emerging market context, as a nuanced approach is typically required.