RBI keeps policy rate unchanged; flags inflation risks, fiscal deficit

Five Monetary Policy Committee members vote in favour of status quo; one votes for 0.25% rise

The Reserve Bank of India (RBI) kept policy rates unchanged for the third consecutive time. Governor Urjit Patel indicated that the recent rise in bond yields was beyond the control of the central bank and a result of fiscal profligacy by the government and the rise in rates in advanced economies. 

Patel’s post-policy statement assumes significance for interest rates in the economy; particularly when his deputy Viral Acharya said RBI was not there to provide liquidity to manage bond prices. According to bond dealers, the statements indicate the RBI was not interested in yield management anymore and the government will have to heed the market. This could mean a yield push up, which will eventually feed into the bank lending rate at a time when the RBI is working on linking the lending rate to a more market-driven external benchmark. 

“Now the RBI has made it clear that the market has to find its own level. Therefore, when fresh borrowing starts in April, the government will have to accept market pricing,” said A Prasanna, chief economist at ICICI Securities Primary Dealership.  

The six-member Monetary Policy Committee (MPC) voted five to one to maintain a pause. RBI Executive Director Michael Patra voted for a hike of 25 basis points, but external member Ravindra Dholakia, who until the last policy had advocated a cut, voted for a pause. 

Following the policy, the repo rate remained at 6 per cent and the policy stance neutral. The tone of the policy was moderately hawkish, as the RBI revised up its inflation outlook marginally for the next year, while lowering growth projections a bit to 6.6 per cent for the current financial year, down from 6.7 per cent it had expected earlier. The RBI revised its inflation forecast up at 5.1 per cent for the March quarter, higher than its earlier forecast of 4.3-4.7 per cent in the second half of 2017-18. 

In the first half of FY19, the retail inflation print would be in the range of 5.1-5.6 per cent, but might cool to 4.5-4.6 per cent in the second half, it projected.

In the policy statement the MPC noted the inflation outlook was clouded by several uncertainties on the upside. The staggered rise of house rent allowance by various states may push up headline numbers and may be generalised. Rising crude oil prices remained a challenge, while elevated minimum support prices for crops may also end up raising prices, “although, the exact magnitude of its impact on inflation cannot be fully assessed at this stage”.

The hike in Customs duty was a risk, while the government’s fiscal slippage would have a broader macro-financial implication, notably on economy-wide costs of borrowing. This may feed into inflation. Domestic fiscal developments and normalisation of policies by major economies “could further adversely impact financing conditions and undermine the confidence of external investors. There is, therefore, need for vigilance around the evolving inflation scenario in the coming months”, the statement said. But there are mitigating factors and there are chances of oil prices cooling down.  

“Our projections indicate that there may be slight rise in inflation this quarter, but during 2018-19 it will remain around 4.5 per cent. Which is why, there was no reason to change the monetary policy at this point, and over the coming three to four months, we will take decisions depending on the data we receive,” Patel said.

Economists saw this as a moderately hawkish statement, less than what the market was expecting. 

“The MPC signals a prolonged pause, but the odds of a rate hike in 2018 are increasing,” said Gaurav Kapur, chief economist of IndusInd Bank. 

The likelihood of actual inflation drifting towards the upper level of the inflation tolerance band (6 per cent) has increased, and “that may call for not only vigilance on inflation but a pre-emptive rate hike in July or August without changing the neutral stance”, Kapur said.

The statement said the economy was on a recovery path, including early signs of a revival of investment activity, but “the deterioration in public finances risks crowding out of private financing and investment”.

Patel was also unusually frank in his assessment of the multiple tax burdens faced by investors as well as multiple counts of fiscal slippage, which pushed bond yields up.

“We have news of fiscal slippages at three levels in recent times. Fiscal slippage this year, a fiscal slippage next year compared to what the market expected and what the target was, and then, a postponement of the medium-term adjustment even further,” Patel said during the post-policy interaction. Besides, five separate taxes on capital would “obviously have impacts on investment and saving decisions”, he said. 

“Having a fiscal stance that is conducive to achieving the 4 per cent (CPI inflation) target is important and significant, and to postpone deviations from them would make matters more challenging going forward,” Patel said. 

He also tacitly pointed out that the RBI would not give any out-of-term dividend to the government, no matter what the demand was.