Monetary Policy – Beginning of Another Rate Cycle

The decision of Monetary Policy Committee to hold back rates while changing stance from “Neutral” to “Calibrated Tightening” looks a little complex. However, more complex and interesting is the reaction of the market which was expecting a rate hike. Contrary to welcoming the pause decision, Sensex went down by massive 792 points! So, what explains this? How would markets have reacted if the policy rate was hiked? A bigger fall or could it have been a thumbs up??! A brief attempt to read today’s monetary policy..

Despite the August inflation being lower than projected, the policy statement paints a grim picture for near term inflation outlook. And the risks are obvious, continued rise in oil prices, being the first. What makes matters worse is that in their recent outlook, OPEC mentioned “subdued demand growth” as key risk for oil producers in 2019! While RBI mentions that the excise cut of Rs 2.5 would help contain inflation, which is probably expecting too much. There is little room for complacency to oil dependent countries like India. It may be noted that oil price is among the five most important factors affecting inflation.

The second factor and this is something that affects the core inflation is substantial improvement in capacity utilization. CU (Seasonally adjusted) has been rising steadily from its lowest level in Q3’FY17 (the Demonetization quarter) and at 74.9% has almost touched the long term average of 75%. It had gone below the 75% level in Q4FY13 i.e. more than five years ago and has been lower since then. So, now when they get back their pricing power, manufacturers are going to hit back with a vengeance! Yet, another reason why inflation may go beyond the acceptable range is continuous depreciation of rupee.

So, is the RBI oblivious to these risks and why has it not raised rates? The answer probably lies in change of policy stance from “Neutral” to “Calibrated tightening. This means RBI motes that the trajectory of inflation is going to be upwards now and any future policy decision would be taken with that bias. It may be noted that it changed the stance from “Accommodative” to “Neutral” in Feb’17 i.e. 18 months back. This is approximately the time it takes for interest rate change to impact the economy. So, if the inflation is benign at the moment, it would be attributable to RBI’s measures taken around that time. Further, since it has already raised rates on last two consecutive occasions, a further tightening may actually be unwarranted.

So, what is the mystery of equity’s sell-off?? The answer probably lies in rate hike by US Fed last week when it also articulated its intention to continue with its tightening. So, were the investors waiting to see if RBI hikes rates to be at par with Fed; in the absence of which, it is flight of capital back to US.

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