RBI Policy: Experts discuss what the MPC should do

Sen said, “The first question we need to ask is what is going to happen in the US. We know duties have been raised and have a cost push effect, inflation is going to inch up and will the US Fed have even more aggressive rate hikes that had been planned.”

The second question is stock markets around the world are jittery and in a situation like that, one does not know where the liquidity will flow?

Ghosh said since the last policy there have been lot of changes in global and domestic markets. US Fed has hiked rates with possibility of hike in June. However the good thing is that, US Fed is looking at rate hike gradually and not at an exponential state.

Talking about the impact of Fed hikes on forex, fixed income markets, Ghosh said, “The rupee has been remarkably stable in the last few days, and possibly due to some RBI intervention in the market,” adding that this is a positive thing.

Fed rate hike has not impacted the domestic forex market significantly for the time being, said Ghosh.

According to Varma said, “Despite the near-term inflation positive surprise there are upside risks and the biggest risk is stemming from the government’s policy decision with respect to the minimum support prices (MSP),” adding that there still seems to be ambiguity with respect to the cost measure that will be used and impact that could have on future inflation. So, we will need to wait and watch on how this play out.

Below is the verbatim transcript of the interview.

Q: First the external environment, especially the trade tit for tat how should that be parsed by the Monetary Policy Committee?

Sen: It is not a tit for tat yet. There is a lot of savour rattling going on. What has happened is, there is huge amount of uncertainty. The other thing that has happened is that the dispute resolution mechanism of the WTO is coming under fire. Now none of this is good news. Now the real question is, what can the monetary system do about it? I think the first question that we need to ask is what is going to happen in the US? We know that duties have been raised, it is going to have a cost push effect, inflation is going to inch up, will the US Fed actually have even more aggressive rate hikes than had been planned? That is a possibility which one really needs to watch out for.

The second is the fact that the stock markets around the world have crashed and continue to be extremely jittery. Now in a situation like that we do not know where the liquidity is going to be flowing to. What is going to happen with that? Then of course you have the big problem which is that if it comes to in fact a trade war then we are looking at countries across the world facing the prospect of slowdown and in a situation where there is practically no room for monetary easing except in countries like India. So, it is a difficult period.

Q:  Markets, from the previous policy to the upcoming policy in the first week of April what have been the changes to the markets mood, the fixed income market and in foreign exchange market?

Ghosh: Since the last policy when it was announced in February there has been a lot of changes in the domestic market and in the global market. The Fed has gone ahead with the rate hike and as of now if you look into the Fed statements there is an 82 percent probability of a rate hike in June and if that rate hike comes through the rate hike in the next September could be at 51 percent. However, the good thing is that Fed is looking at a rate hike gradually and not at an exponential stage. So, this is the important thing.

However, the other aspect which we need to keep in mind regarding the Fed rate hike is that since the Fed is also controlling lose fiscal policy so if you look into the federal debt that has actually now gone up to USD 21 trillion. The student’s debt has gone up to USD 13 trillion so at some point of time the rate hikes which the Fed is saying and that is the reason why I said that the gradual rate hikes the Fed is doing is going to take a hit. So, my sense is that even though the Fed is pushing forward for a guidance for an rate hike of close to three in this year, three next year and two in the following year I think still there is going to be some amount of adjustment given the debt overhang in the system.

Now how does it impact the foreign exchange market and the fixed income market? As far as the foreign exchange market is concerned I think the rupee in the last couple of days after the recent happenings in the financial market on the trade front, on the bank front I think the rupee has behaved quite remarkably stable and possibly due to some sort RBI intervention in the market. So, that is the positive thing and there is the feeling in the market that this around USD 80-100 billion of trade exposures which the banks have got could actually find some sort of an adjustment in the next three months. So, therefore the importers are not rushing into the market for covering their positions that is helping the rupee to stay stable. So, in my sense the bottom line is that even though the Fed has gone ahead with the rate hike but at the same time it is not having that amount of impact on the domestic foreign exchange market at least for the time being. Possibly it could have an impact two to three months down the line if there is come amount of adjustment on the trade front.

Q: What should the inflation view be considering that we have got a surprisingly low food inflation number last time around?

Varma: I think in the near term clearly inflation has surprised a bit on the long side mainly because of food prices coming off. But also I think both in January and February the momentum in core inflation has moderated and our measures of underlying inflation are actually between 4-4.5 percent so the headline core CPI of 5 plus clearly exaggerates the underlying inflation. But despite the near term inflation positive surprise I think there are clearly upside risks. The biggest risk stemming from the government’s policy decision with respect to the minimum support prices there still seems to be a lot of ambiguity with respect to the cost measure that will exactly be used and the potential impact that could have on future inflation I think that is still a risk. We don’t have clarity on this we will need to wait for another couple of months before we have a clarity on how this plays out. Second the risk on account of oil prices moving up.

So both those factors suggest that yes, near term inflation has moderated but I think risks are still very much on the upside particularly stemming from government policies around food inflation.

Q: I would not normally have brought the growth picture into the discussion but there was a stunning last sentence in the previous monetary policy and I want to read that, “The committee is of the view that he nascent recovery needs to be carefully nurtured and growth put on a sustainably higher path through conducive and stable macro financial management.” Clearly the committee is keeping the nascent growth on its radar and that may have gotten a bit tough despite good commercial vehicle numbers and PMI numbers. There is a problem in the banking system because of the accelerated recognition of NPAs. So what should the MPC take on board with respect to growth concerns?

Chakraborty: It is a difficult policy from that perspective because the data which is out in public is showing not only a significant year over year improvement in most of the growth parameters but also a sequential improvement on a seasonally adjusted month on month basis. However on the other hand at least two big concerns have evolved over the last few days which could have a meaningful bearing on the growth numbers, one is as Pronab Sen discussed - the trade related uncertainty, the other is related to the whole banking sector issue- not just the issue of bank fraud but also the issue of the IBC process itself not moving fast enough and whether there is enough growth capital available to the banks after all this.

So, these two headwinds could mean that the sequential improvement that we have seen on growth could be much short lived and that's the risk that the committee will have to keep in mind. While I accept Sonal Varma’s point about some upside risk to inflation, similarly there are downside risks to growth. So, it is just the opposite - that the actual inflation number has been lower than expected and the risks are to the upside. Actual growth numbers have been higher than expected but the risks are to the downside.

Q: How should the RBI and the MPC take on board the fact and that cannot be ignored, that banks are not desiring to buy bonds now. Is that a factor that MPC has to contend with although it is not its core mandate?

Chinoy: MPC has stuck to its mandate and that just should be the focus going forward. The mandate has to be, it is a flexible inflation targeting approach. My first call of duty is to keep inflation close to 4 percent subject to that realisation, I should focus on where the out gap is.

I think a lot will depend on how forward looking the MPC is because today you would think inflation is surprising to the downside and the growth concerns that the MPC spoke about have alleviated because you have this one GDP print above 7 percent, next quarter will also be above 7 percent, high frequency is doing well. However if you go 3-4 quarters down, what you see is inflation risks are very much skewed to the upside for two reasons – we haven’t discussed the fact that oil is back at USD 70 per barrel and with Saudi Arabia saying what they did, this is much more supply than demand in the last week or so, so if your view is going to be oil is going to be close to USD 70 per barrel for the rest of this year, I think first the MPC has to mark to market its own inflation forecast which was predicated with oil at USD 55 per barrel. The second is the food price increase that will come in the second half the year because of any MSP increase.

Both food and fuel have a critical bearing on inflation expectations. So, later in this year if you look at higher fuel prices, higher food prices because of the governments MSP policy, that will ultimately feed through into core inflation as well.

So the first thing is, how forward looking is the MPC willing to be, ignore the inflation prints for the next 4-5 months, March inflation may come all the way down to 4 percent, the second quarter has got unfavourable base effects, until September you have got both GST and the HRA allowance distorting the year on year prints. The first clean number we will get is going to be closer to October.

So, what I will be looking at is, what is the second half fiscal year inflation forecast for the RBI? If that number is 5 percent or thereabouts, then the MPC will get concerned because that is meaningfully higher than the 4 percent.

Q: So, you expect a change in the fan chart which the RBI will put out?

Chinoy: April is the full year review, that is when the RBI revisits all its assumptions on growth and inflation. With oil at USD 70 per barrel now, I would expect that, that fan chart will be revised.

Q: What should the doctor prescribe? There are of course dangers to growth no two ways about it. E-way bill will start in April that also is going to have its own disruption to growth. Nevertheless the mandate is inflation and crude is at USD 70 per barrel. What should the MPC do by way of action?

Sen: With factors like that, you really can't go by looking simply at what the current price of crude is because we are now in a world where the crude prices are going to yo-yo because the shell oil producers will be moving in and out of production depending upon how prices are behaving. So oil is going to be range bound but it is going to move around and I don't think we should get terribly worked up about its immediate short run movement. So, I wouldn’t worry too much about that.

So, far as the upside risk to inflation is concerned which is in terms of the MSP, again I won't worry too much about it. The fact of the matter is that the MSP is only as good as the government’s ability to support that price. The fact is that the institutions infrastructure is simply not there. You can announce any price you want but the market is going to be doing exactly what it thinks it should be doing. It won't care about the MSP very much. So, I don't think that is an immediate risk. It will become a risk if the government’s procurement infrastructure or the deficit payment arrangements become stronger, then the ball game changes but that's not happening in the next season.

At the moment I think the real issue is, what's going to happen on the growth side both for domestic reasons as well as for global reasons. In this particular situation I would probably be a little cautious because as far as growth is concerned you really don't have to be ahead of the curve. Inflation is a different ball game. On growth you don’t have to be ahead of the curve, so that's what we should be looking at.

Q: Although 2-3 policies ago the RBI cut after coming to neutral, bond yields have since gone higher despite the last two weeks mellowing and MCLR rates have been hiked by banks, so quite contrary to what the RBI did. How should the RBI tackle this?

Ghosh: I think here there is actually the peculiar conundrum of the bond market. I will just give you some numbers, for example currently if you look into the core liquidity in the banking system, which is basically the liquidity after adjust for the government cash balances, that has declined from an high of around Rs 4 lakh crore in the beginning of this year to less than Rs 1 lakh crore, I think around Rs 80000 crore. If you look into the repo numbers, the repo or term repo and net it off with the reverse repo including the term reverse repo you will find that the system is already running at a deficit of around RS 50000 crore. So my sense is that the system is running at a deficit and other important thing is that if you actually look into the spread between the 10-years yield and the repo rate, the spread is currently around more than 170-180 basis points on the old paper. Historically the median spread between the two papers has been around 70 basis points.

So I think there is an element of irrationality in the market and the other important thing is that if we juxtapose a calculation by looking into the demand-supply maths of the bond market in the next year, you will find that even if you are assuming say a 10 percent growth in the banks NDTL and assuming that the market shares of the banks - scheduled commercial banks, primary dealers, mutual fund remain at the same level which it was in this year, you will still find that there could be a deficit of close to Rs 1.5 lakh crore in the banking system in terms of the papers to be absorbed by the market. So at some point of time the RBI needs to seriously address this issue. How does it want to, whether it wants to inject liquidity or whether it wants to do it through a permanent mode or other mode, otherwise what is going to happen is that the bond markets will stay at an elevated level and at some point of time it could have some amount of a negative impact on the market sentiments.

Q: So what should the MPC do? I mean it it's quite clear that there is a tightness even though I would assume that actually the liquidity tightness was not as much given the advance tax payout. There were people expecting Rs 1.5 lakh crore of deficit, the deficit was lower than that. But that apart do you think the MPC has to concentrate on the way in which prices might rise because of trade and because of crude or do you think now growth needs a helping hand what should the tone be for instance?

Varma: I think we're still in the wait and watch zone I guess right now. There are risks to inflation like I said because of MSP and oil. Just one point with respect to Pronab Sen’s point on the procurement infrastructure of the government not being there, that's very true. At the same time the government is also trying to ensure that the MSP actually becomes an effective floor through some form of fiscal transfers to be made to farmers.

So I think government policies around food inflation are changing and there's a lot at stake because of the election cycle. So I think we have to be cognisant of the upside risk that that poses both to the inflation and the fiscal outlook. At the same time like underlying inflation as of now is between 4-4.5 percent, growth has picked up but there has been an effective tightening of lending standards and the banking sector issues mean that whatever growth capital one had assumed back in October after the recapitalization, that has completely vanished.

So there is a strong cyclical recovery at the same time there are concerns on the sustainability of this growth cycle. So I think at this stage we are basically in a wait and watch like I said specifically with respect to government policy on MSP. If that is substantially high then despite the adverse growth impact we are seeing and if that triggers huge second round effects, leads to higher core inflation, leads to higher inflation expectations in the backdrop of what's happening globally in terms of risk and domestically with respect to perception around the macro risks in India, I think that would trigger some response. However at this stage it is a wait and watch.

Q: Do you expect them to change their inflation forecast?

Varma: In the April policy we are broadly in line with the projections laid out in February. So not at the April policy.

Q: Do you expect them to change the growth or inflation numbers? More importantly would you look for signs whether the RBI will, the MPC will stick to that 4 percent, plus or minus 2 percent or would you look for them to not be so symmetrical and be comfortable with 4 percent?

Chakraborty: So on your first question, I think all the risks that we are talking of both on the growth side as well as inflation side, there are so much imponderables there that it's too early for them to shift their inflation trajectory based on these factors. How much MSP hike will happen, how much will be the pass through to market prices, these are pretty much open questions at this point of time. Similarly on growth concerns, how much this banking slowdown is going to hit growth or how much trade slowdown is going to hit growth, are all risks at this point but difficult to quantify.

So, I suspect that the trajectories will not be changed too much. However the interesting point is about the response function to these trajectories. When in February these trajectories were put in place, one would have wondered that with the projected trajectories staying more than 4 percent for such a long period of time there should have been some action to bring it down to 4 percent almost immediately as a proactive measure. However since RBI did not do that, now with almost an unchanged trajectory it will be difficult for them to take action till the point if Sajjid is right that the second half trajectory at some point of time needs to be upped then there is a question of a response to that. But before that it appears that they are going to use the 2 percent plus / minus band on both sides quite symmetrically the way RBI was not too keen to cut when inflation dropped to 2 percent or below also.

Similarly when if it stays within that 4 to 6 percent range there will not be too much of pressure to hike. As Sonal Varma was also mentioning that they are looking at some kind of core number which is still staying between 4-4.5 percent which would give them some comfort that this is not a runaway inflation.

Q: Since you were worried about several inflation inducing factors are you expecting a change in their trajectory? Do you think that you would look for this tone of sounding comfortable with 4 percent plus inflation for the foreseeable future?

Chinoy: The second question is easier to answer. If you look at the minutes of the last meeting, it was very clear that the RBI said, 12 months ahead if inflation is meaningfully above 4 percent, that would perhaps trigger a change in stance. Now what that meaningful number is, is it 4.8 percent, is it 5 percent? So I am not sure that at inflation down the road close to 5 percent, this MPC in its infant stages of inflationary regime would be very comfortable. Once we get close to 5 percent on a sustainable basis not for one or two months, but if for 2 or 3 quarters the inflation projections, forecast inflations being close to 5 percent then I think that would warrant a change in tone, a change in stance.

Q: Are you expecting one in 2018?

Chinoy: I think a lot will depend on because these are all risks, how much of these risks become part of the baseline. In February want the MPC said is, they are still assuming oil at USD 55 per barrel and they are still not going with any extraordinary MSP increases in the inflation forecast. Is there sufficient information between February and April for some part of that to go into the baseline? If the answer is yes, I think the second half inflation trajectory changes to the upside. If the answer is, there is still too much uncertainty, maybe we have to wait for another review.

This is what happens when you get these, what I call adverse supply shocks because a mandated increase in MSPs, higher oil prices and global trade wars are adverse supply shocks. If both things happen at the same time, growth abates and prices go up and monetary policy making is never easy given that combination of circumstances.

Q: It is time to vote. First question is what should the action be? Should it be a pause or hold, should it be a hike, should it be a cut?

Ghosh: It is a pause in this policy.

Chakraborty: Pause.

Chinoy: Pause.

Varma: Pause.

Sen: Pause.

Q: Can the MPC do something with its tone, the tone of the statement? What do you expect the tone will be – neutral, dovish?

Ghosh: I expect it to be neutral to cautious statement.

Chakraborty: Neutral.

Chinoy: Neutral to cautious.

Varma: Cautious.

Sen: Cautious on growth.