R K PATTNAIK AND JAGDISH RATTANANI
There are three simple things to note from the decision by the Monetary Policy Committee (MPC) to hike the policy repo rate from 6.0 per cent to 6.25 per cent. First, the decision to hike the rate is unanimous. All six MPC members have voted in favour. Second, the hike comes after a very long pause – the last rate hike was four-and-a-half years ago. In that sense, this is a turning. Third, the increase in the Indian crude basket, which was sharper and earlier than expected, is now being read by the MPC as “durable.” Which means oil will continue to play some havoc with prices. The MPC also noted that volatile crude prices lend considerable uncertainty to the inflation outlook – both on the upside and the downside. As election season nears, the upside will worry the political establishment.
The unanimity of the decision announced by the MPC on Wednesday is important because this tells us how much the situation has turned. Quite appropriately, the “wait and watch,” which is what many in the market expected, has given way to action. To do so with unanimity also tells us that the MPC as an institution has matured and is no more tentative. It is able to take a firm decision and does not hesitate to pull its punches when the situation calls for it. The trigger for a rate hike is the increase in headline retail inflation measured in terms of consumer price index (CPI) and the rise in core inflation (headline inflation excluding food and fuel). The mandate given to MPC is to keep CPI inflation of 4 per cent, within the band of 2 per cent up or down. So the MPC fails if inflation reaches even near 6 per cent.
According to April data, the headline inflation was 4.6 per cent and core inflation worked out to 6.2 per cent. As against the projection of inflation in April 2018 at 4.4-4.7 per cent for the first half of 2018 and 4.4 per cent in the second half, the CPI inflation has been revised higher at 4.8-4.9 per cent in H1 and 4.7 per cent in H2 with upside risks emanating from the rise in international crude prices. Apart from this, there are risks of increase in global commodity prices. In addition, there are upside risks emanating from significant increase in household inflation expectations. As the MPC reported on Wednesday, the May 2018 round of the Reserve Bank’s survey of households reported a significant rise in households’ inflation expectations of 90 basis points (bps) for three months ahead and 130 bps for the one-year ahead horizon. The rate hike also has taken into account the favourable outlook on economic growth for 2018-19 and accordingly retained the April 2018 projection of 7.4 per cent in the range of 7.5-7.6 per cent in the first half and 7.3-7.4 per cent in the second half. This means the MPC says that growth will remain on track. The question is will the rate hike adversely impact growth? The answer should be no because the output gap is closing. This means that the economy will be working to its full potential at 7.4 per cent as projected. At the same time, if inflation persists beyond what is projected, the MPC is likely to act again. That will be the time to worry because further action will hit growth. Therefore, growth cannot be taken for granted.
Sustaining economic recovery
There remain a few question marks on whether economic recovery will be sustained. The most critical structural impediments are supply side bottlenecks arising from the productivity and efficiency of the Indian economy. The Indian economy has recovered but still consumption-led growth (both by the government and the private sector) predominates our economic growth. Government investment has been blocked with rising consumption expenditure fuelling revenue deficit.
Since 2019 is an election year, expect consumption expenditure (both at the Centre and the State) to go up, resulting in higher borrowings. With the vicious cycle of deficit and borrowing, the interest rate will go up for the government sector and thereby will crowd out private sector borrowing and investment.
Of course, the immediate worry is oil, and a lot more can go wrong if the prices persist at this high level or turn further up. In this light, as the RBI Deputy Governor Viral Acharya has clarified that the inflation projections have taken a full pass through of the rise in crude prices. Which means the oil companies/government will take no hit – it’s all passed on to the consumer. And thereby hangs another tale of public anger versus fiscal management, made all the more complex as election nears.