The RBI hiked policy rates by 25 bps (Repo: 8 %) and deftly moved closer to a flexible inflation targeting approach, committing to a glide path that would bring CPI headline inflation down to below 8% in a year’s time, as per the recommendations of the Urjit Patel Committee Report (see,” RBI Expert Committee recommends move to flexible inflation targeting,” Morgan Markets, January 22, 2014).
Markets were surprised by the rate hike because with the RBI choosing to stay on hold in December, headline inflation moderating by 130 bps since then, food prices continuing to correct, growth continuing to disappoint, and uncertainty about when the Committee report would be adopted, the majority – but not all -- market participants had expected the RBI to stay on hold (Consensus and JP Morgan: on hold). However, we had expected it to be a very close call since one of the pre-conditions for staying on hold in the December guidance – that core must moderate -- had not been met (see, “RBI likely to stay on hold, but it’s a close call,” Morgan Markets, January 27, 2014). Before today’s review, we had penciled in 75 bps of rate hikes in 2014 and, after today’s hike, re-affirm our view of another 50 bps of hikes in the second half of the calendar year.
To its credit, the central bank indicated that one of the reasons for today’s hike is that it takes its guidance very seriously. The guidance had explicitly indicated that barring a substantial moderation in headline inflation and a moderation in core inflation, the RBI would act. And while the first condition had been met, the second had not (see, “RBI’s CPI dilemma: it depends what “is” is”, Morgan Markets, January 13, 2014) triggering the hike.
Don’t miss the forest for the trees
But only focusing on last review’s guidance, this review’s action, and the rate outlook in the near future runs the risk of missing the forest for the trees. Because, today’s monetary policy review – both explicitly and implicitly – signals a significant departure from the extant multiple-indicator approach towards a flexible inflation-targeting framework based on the headline CPI.
- For starters, the RBI has focused exclusively on headline CPI inflation in the policy review, adopting the glide-path recommended by the Urjit Patel Committee of bringing headline CPI to below 8% in a year’s time. The RBI indicated that today’s hike was necessitated by the fact that, absent policy action today, there were “upside risks to the central forecast of 8%.” This clearly indicates the primacy of a quantitative CPI headline target in monetary policy decision-making. Revealingly, there was absolutely no mention or forecasts of the WPI, which used to dominate previous reviews.
- Interestingly (and to the RBI’s credit) there was no talk about a growth-inflation trade-offs. The Governor reiterated at the press conference (and we strongly concur) that at current levels of retail inflation and inflationary-expectations, there is no trade-off between growth and inflation. The policy backed up this line of thinking by indicated that “if policy actions succeed in delivering the desired inflation outcome, real GDP growth can be expected to firm-up from a little below 5 percent in 2013-2014 to a range of 5-6 percent in 2014-15” This clearly suggests that the central bank believes – and we agree – that bringing down inflation from current levels is itself growth-enhancing and not growth-inhibiting. It also reinforces the primacy of bringing down headline CPI inflation above other objectives over a one-year horizon.
Where to from here?
One of the many advantages of laying out a transparent, quantitative target to be met in a year’s time (Headline CPI at 8% in a year) is that it takes away the uncertainty of the past (about whether the primary objective was growth, headline CPI, core CPI, headline WPI, core WPI, the exchange rate) and is therefore better able to anchor both market and household expectations.
However, even if there clarity on the end-goal, there can still exist differences on the assumptions needed to get there. The RBI noted that “the extent and direction of future policy steps will be data dependent, though, if the disinflationary process evolves according to this baseline projection, further policy tightening in the near-term is not anticipated at this juncture”
With food prices continuing to correct sharply in January – and expected to do so until the general elections – and growth momentum likely to weaken further in 1Q14 (on the sharp fiscal squeeze needed for the government to meet its budgeted fiscal deficit) expected to put some downward pressure on core inflation, we expect the RBI to stay on hold at the April 1st review. (Per the Urjit Patel Committee recommendations, monetary policy will move to a two-month cycle instead ofa six week cycle).
However, under our baseline assumption of a growth pick-up in the second half of the year, post the elections, we expect inflation momentum to rise, and pencil in another 50 bps of rate hikes in the second half of the calendar year, consistent with our view that output gaps may not be as negative as presumed (see, “Special Report: India in 2014 – five questions that keep us awake, “ MorganMarkets, January 27, 2014)
Markets are likely to focus on the timing and likelihood of the next rate action. But the more important message from today’s review is that the transition to a more transparent, rule-based monetary policy framework at the central bank, with price stability as its overarching medium-term objective, is well and truly on.
Disclaimer: this author served on the Urjit Patel Committee to strengthen and revise the monetary policy framework.
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