With inflation rising, MPC may harden stance

Interest rates in key markets are rising after a prolonged period of record-low rates. On account of improving real economic data, and continued strong labour market gains, the Federal Open Market Committee in the US increased the federal funds rate by 25 basis points to a target range of 1.75-2 per cent in June 2018.

The other two major central banks — the European Central Bank and the Bank of Japan — are also shifting their monetary policy stance. The ECB decided on June 14 to end its quantitative easing programme by the end of 2018. The BoJ is also expected to make a shift from its aggressively accommodative monetary policy, with the Japanese 10-year bond yield increasing to 0.83 per cent from 0.32 per cent on July 23, making it the largest one-day yield change in over two years.

With the US Fed hikes, halting of ECB’s quantitative easing and a likely change in the BoJ’s policy stance, global liquidity is expected to tighten, thereby leading to a reallocation of funds. This has triggered an increase in interest rates in other geographies. Several emerging economies have increased their interest rates in the last three months. The impact of increase in global interest rates is also evident on the Indian economy. In the past, India benefited much from foreign capital attracted by the interest rate differential between India and the US. Understandably, increase in Fed rate, coupled with escalating trade tensions and macroeconomic uncertainty, has started to impact foreign institutional investments in India.

Net portfolio investments recorded outflows of ₹61,130 crore during April-June 2018 against inflows of ₹78,930 crore during the corresponding period of 2017. In fact, the overall monthly foreign investment inflows turned negative for the first time after 16 months in May 2018. India depends on capital inflows to fund its large current account deficit and the recent trend is a matter of concern.

It is against this background that the Monetary Policy Committee (MPC) will be holding its third bimonthly meeting. The domestic macroeconomic conditions, as it is, already warrant an increase in the policy rates. The developments in the external sector are likely to only reinforce the case for a rate hike.

Inflation, growth

The MPC framework was instituted with the objective of maintaining price stability, while keeping in mind the growth objectives. The target inflation rate for MPC up to end-March 2021 is 4 per cent, with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent. At 5 per cent, the retail price inflation in June 2018 is well above the target rate of 4 per cent, but within the upper tolerance limit. Inflation has been higher than the target rate for eight consecutive months and is expected to remain high. Food inflation is likely to spike on account of increase in minimum support prices, and supply-side issues in some areas. Spiralling crude oil prices may also have an impact on the CPI, but the share of products which are directly impacted by changes in crude oil price have a weightage of only 4.3 per cent in the CPI. Increase in oil prices may lead to a gradual increase in the cost of producing other goods.

Along with a rise in inflation, economic activity is also expected to maintain growth momentum. India’s economy is expected to grow by 7.4 per cent in 2018-19, supported by robust investment activity following the improvement in capacity utilisation and credit offtake.

In the first two months of the current financial year, non-food bank credit witnessed double-digit growth on the back of revival in investments. Exports are expected to increase on account of buoyant global demand, which will provide a further boost to investment. During the first quarter of 2018-19, India has already recorded double-digit export growth of 14.5 per cent. Consumption sentiments are also improving on account of improving business conditions.

Outlook

The long period of very low, and in some cases, even negative interest rates have contributed to economic upswing in major economies. The world is now moving towards a normalisation of monetary policy, and India may follow a similar path. Economic activity in India is expected to accelerate on account of strong private consumption, recovery in exports and infra investment.

Inflation is also well above the target rate and may be further stoked by higher oil prices. These developments will weigh in on the MPC at its forthcoming meeting. While there is a strong case for an increase in the repo rate, the MPC is likely to remain cautious and adopt a wait-and-watch policy, although it may well shift from a neutral to a tightening policy stance considering expectations of higher inflation in the medium term.

The writers are economists with the Export-Import Bank of India. The views are personal.