August India MPC Preview

(The following article appeared on cnbctv18.com on 31st July 2018. 

https://www.cnbctv18.com/views/rbi-monetary-policy-the-case-for-and-against-raising-rates-409951.htm )

August India MPC Preview

Analyst polls and market prices indicate expectations of a 25bps repo rate hike tomorrow, when the monetary policy committee (MPC) releases its third bi-monthly statement. 

Is a rate hike likely? What does the MPC’s current “neutral” stance really mean? What is the outlook for system liquidity and markets?

The overt case for a rate hike

There are core arguments for a rate hike tomorrow. 

First, since the previous MPC meeting, the government has delivered on its promise of sharp increases in minimum support prices (MSPs) for crops. So far, the MPC had politely chosen to wait-and-watch on MSP, even as the broader market saw this as inevitable. Now, notwithstanding soft food inflation prints and monsoon progress since its last meeting, the MPC must finally factor the impact of MSPs – particularly paddy prices – on second half (H2) CPI. Unless its models echo the government’s protestations that higher MSPs will not impact CPI inflation, H2 CPI could be revised up from 4.7% to at least 5.0%. 

Second, since the last MPC meeting, the global context has continued to look murky. This may not be the time to risk loss of credibility by not delivering on rate hike expectations. 

The covert case for vigilance

There are other arguments that should weigh on MPC sentiment, even if they are not explicitly stated. Our old nemeses – the twin deficits – have been knocking on our doors for a while now. 

On the external front, we face a wide current account deficit (CAD), alongside a reversal of previously accumulated carry-seeking flows. Robust defense of the rupee is already underway, with strong RBI intervention, alongside elevated interest rates and forward premia. 

MPC action and RBI intervention deeply impact the external balance, but both remain silent on this subject. For now, happily for the government this election year, the RBI has chosen to expend its currency reserves to defend 69.00 on USDINR. The basic imbalance persists, however - we are looking to fund our current oil, gold and phone purchases by borrowing expensive and/ or fickle money. 

RBI currency intervention buys us time, but does not directly address this imbalance. Our exports need help, we need to modulate our imports, and we need to get our net FDI up again. The recent rupee weakening may help, but it isn’t clear how a sustainable external balance can return, unless say our collective prayers for sharply lower oil prices are answered. 

On the fiscal front, we could see a slippage this year. While the MPC may be too polite to point this out, the budgeted GST collections look ambitious, and MSPs and oil subsidies will stretch expenditures. In addition, as in FY18, both the center and states could be tempted to give out election year doles. While RBI’s dividend payment may be a positive surprise, the quality of the deficit will likely deteriorate, with a rise in revenue deficit alongside a drop in capital spending. 

If history is any guide, when questions arise about financial stability, we have little choice but to be cautious and vigilant. We need to at least meet market expectations on higher policy rates.

The “neutral” monetary policy stance

As ever, there are counter-arguments as well. 

First, Citi’s latest analysis demonstrates the difficulty of modeling the impact of MSP increases on CPI. The broader point remains true – given our CPI’s 56% food and commodity weightage, predicting its trajectory is a hazardous task. Perhaps a wait and watch could be justified – again. 

Second, with it’s current “neutral” policy stance, can the MPC deliver back-to-back rate hikes with a straight face? If it does, what does a “neutral” monetary stance really mean? Does it indicate a pause, unless incoming data were to truly surprise in some form? If so, what was the surprise since the June meeting? Does a neutral stance also indicate a shallow rate hike cycle in the current context?

Clarifying this may be important, since the stance has been at variance with market signals for months now. The current policy repo rate is 6.25%, 1-year T-bill is at 7.25%, and 10-year bond is at 7.80%. Swap and corporate bond yield curves are steep as well. We can debate the factors that cause this steepness, but the market is pricing in a steady rate hike cycle. It is difficult to reconcile this with the current “neutral” MPC stance. 

The MPC should consider moving away from a neutral stance, to one of a withdrawal of accommodation. Incoming data will obviously inform MPC action – that is stating the obvious. Given the global and domestic context, however, it may be reasonable to accept what the markets are already telling us – the need to be vigilant. The change in monetary stance can help underscore this vigilance. 

What about liquidity?

Will the MPC and the RBI change their liquidity stance as well? Liquidity has been tight the last few days, and the weighted average call rate – RBI’s favorite (and imperfect) liquidity measure – has edged up. If the MPC monetary stance is changed to one of withdrawal of accommodation, will they also consider moving to the old regime of permanent liquidity deficits? 

The liquidity stance – surplus, neutral or deficit - is an important adjunct to monetary transmission. It impacts money market rates, influences balance sheet management strategy, and informs expectations about RBI’s liquidity and bond open market operations. Ideally, withdrawal of accommodation is best transmitted through a tight liquidity policy. 

On the flip side, money and bond markets have already done the MPC’s job, by creating and sustaining a steep yield curve. Do we really want to pressure the curve (and the financial sector) further?

Bottomline

The rate hike may be a closer call than the market expects, as the MPC mulls realpolitik, the impact of MSP on CPI, and perhaps reconciles back-to-back rate hikes with their current “neutral” policy stance.

The MPC may now consider changing their stance from “neutral” to “withdrawal of accommodation”.

A simultaneous rate hike and change in monetary stance would be an unexpected shock, and hurt bond and money markets.  

On the other hand, a rate hike with continued “neutral” stance might leave bond markets broadly unchanged, even as participants ponder how to reconcile MPC neutrality with bond and money market signals. 

Perhaps the optimal via media for the MPC would be to change the monetary stance to withdrawal of accommodation, without an immediate rate hike. This could actually convey MPC vigilance better than just a rate hike.

The MPC may also choose to maintain silent status quo on its liquidity stance. Changing the liquidity stance to one of core deficit, alongside a rate hike and/ or change in monetary stance, may again be too much of a hawkish shock, hurting the economy at a time when yield curves are already steep. 

The RBI will likely continue its aggressive currency defense. The core external imbalance still needs addressing though.

Lastly, in the short run, a completely no-change MPC statement would be bond positive, particularly at a time when Indian banks are back in action. That could risk the MPC's credibility though. Further, medium term domestic and global uncertainties, including of the H2 borrowing calendar, will continue to weigh on bond sentiment.