Rates Hiked — The RBI and The Indian Economy


RBI raised interest rates for the first time since 2014 pushing the repo rate up by 25 basis points to 6.25%. This decision came as a surprise to many as the expectation was no change in policy. However, banks may have anticipated the move as they increased rates in the run up to the MPC meeting. RBI highlighted its neutral policy stance, implying that decisions will be data driven rather than sending a strong signal about the direction in which it is moving. RBI decided to increase rates keeping in mind evolving global and domestic macroeconomic developments. Economic activity and trade have continued to expand. Inflation has also emerged as challenge in many economies as a result of rising commodity prices of products such as crude that have an effect on the larger economy. In India, inflation rose to 4.2% in April up from 3.9% in March.

The RBI conducts the Inflation Expectations Survey of Households (IESH) across the country. The report released on 6th June showed a rise in inflation expectations in households. The sharp rise can be attributed to households forming adaptive expectations with different bases rates and other factors influencing this. Oil price rise has been the major factor driving inflation rather than food inflation.

Since the MPC meeting in April, crude has shot up by over 15% to $74 a barrel. This has increased input costs. Volatile crude prices are a significant risk for the RBI in carrying out its monetary policy. The sudden movements upward or downward can cause shocks. Based on all these factors, the RBI has forecasted an inflation rate of 4.7%+ for FY18-19.

Inflation targeting is a mandate that the RBI has. It has to keep inflation at 4% (+ or – 2%). A failure to do so for a particular period of time will be considered a failure in monetary policy. Therefore, inflation is one of the biggest indicators the RBI keeps an eye on. The movement of crude oil prices will determine MPC in the near future.

Financial markets have been influenced by monetary policy expectations and geopolitical developments. Emerging market currencies have depreciated against the dollar. There has been a sell off in emerging markets. This has added to the pressure, if not caused it. In an op-ed in the FT, the governor highlighted the impact US monetary policy was having on the rest of the world. The “double whammy” being caused by the fed trimming its balance sheet on the one hand and on the other increasing treasury issuances as deficits are getting larger. This is resulting in liquidity being mopped up. He expects this to have an impact on the dollar bond markets. The impact would reflect in yields moving higher to attract liquidity.

One of the immediate impacts of this has been outflows from emerging markets back to the US. With all emerging markets experiencing similar movements, this spread can be called a ‘contagion’. With capital markets freeing up, funds that flow in and out have a significant impact on the asset classes they are in.

So, the fall in emerging market stocks is a result of these flows rather than any reflections on the fundamentals of an economy. While the fed may not change its policy, a sitting central bank governor writing about the Fed’s policy in a public platform is a big deal and a serious issue.

What this also means is that there is less room for policy error. Hence, the neutral stance by the RBI. The MPC has revised its growth estimate for 2017-18 at 6.7% with all time high agriculture output and strong activity.

The forecast of a normal monsoon has a positive impact on this year’s growth. Capacity utilization has also seen an increase. PMI has been expanding for the 10th consecutive month. The governor also noted the increase in investment that is taking place. The resolution of distressed assets will only boost these investment figures and also boost growth.

The key take-away is that inflation is on the rise and the common man knows it. This was reflected in the survey. The next year or so, inflation will continue to be a challenge. Things are going to get more expensive. Brace for impact! But on the other hand, growth is also strong. Real growth numbers will play an important role this year given high inflation.

There could be some volatility in financial markets as well.

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