MPC hikes rate: A close call

• HDFC securities
• 09 Aug 2018
• Knowledge Centre

To hike or not to hike?

 

After much debate regarding the outcome of the Reserve Bank of India’s (RBI) bi-monthly monetary policy meet on 1st August 2018, the ‘growth-inflation trade-off’ tilted in favor of reigning in inflation again.

 

The MPC hiked the repo rate or the rate at which the central bank lends funds to banks, by 25 bps (basis points) to 6.5%. This was last seen in October 2013 when the repo rate was raised in two consecutive policy meets. The medium-term target for inflation stands at 4% in a band of +/- 2%. The central bank’s stance remains ‘neutral’.

 

Potential Causes

 

RBI cited many factors that could trigger inflation as the reason for its decision to increase the repo rate. These include volatile crude oil prices, geopolitical tensions and supply disruptions. Another cause for ambiguity regarding the outlook for inflation was volatility in global financial markets. A risk to the inflation parameter also came in from households’ inflation expectations.

 

According to an RBI survey, these have ‘increased significantly in the last two rounds, which could influence actual inflation outcomes in the months to come.’

 

Manufacturing firms polled in RBI’s industrial outlook survey revealed that another factor that could stoke inflation was the hardening of input price pressures in Q2 FY19. However, the RBI report stated that this could be countered by the recent softening of global commodity prices. The potential impact of MSP on inflation was another important parameter.

 

This was expected to become fully visible in the coming months, once the price support schemes are implemented. Other factors include the regional distribution of the monsoon and fiscal slippages at the center/state levels. The discussion on the possible increase in inflation early next year (estimate of Q1 2019-20 to 5%) also suggests a long term-view on inflation by the RBI.

 

The ‘Growth Story’ intact

 

The MPC cited aspects that support the fact that growth in the country is on track. RBI’s stated, “Turning to the growth outlook, various indicators suggest that economic activity has continued to be strong. The progress of the monsoon so far and a sharper than the usual increase in MSPs of Kharif crops are expected to boost rural demand by raising farmers’ income.

 

Robust corporate earnings, especially of fast moving consumer goods (FMCG) companies, also reflect buoyant rural demand. Investment activity remains firm even as there has been some tightening of financing conditions in the recent period. Increased FDI flows in recent months and continued buoyant domestic capital market conditions bode well for investment activity.”

 

Supporting growth or stem inflation have been crucial options for the MPC over the years. The decision to hike rates comes at a crucial juncture now, as India stares at weakening macros and a depreciating currency. “It’s important to watch out for the inflation readings in September and October (which could be reflective of the impact of higher MSPs). So far only 20% of the budgeted borrowings for the Central and State Governments have been done with a majority of the supply is expected to come in the second half of the year,” says Deepak Jasani, Head Retail Research at HDFC securities Ltd.

 

The bond market seems to have reacted in a positive way to the rate hike (decline in 10-year yield by 6 bps). This, we believe, is in response to the RBI’s commitment to keeping the liquidity situation neutral instead of allowing the system to move into a large deficit.

 

Despite RBI’s neutral stance, does one more rate hike seem likely in October?