India’s Monetary Policy Committee decided to raise the benchmark interest rate by 25 basis points at its meeting concluded on Wednesday, while retaining a ‘Neutral’ monetary policy stance. The committee voted 5-1 to hike the repo rate from 6.25 percent to 6.5 percent.
The MPC had hiked rates for the first time in four years in June to quell price pressures and bring inflation closer to the mid-point of the committee’s target of 4 (+/- 2 percent). The main reason for changing the policy rate is to ensure that inflation is maintained on a durable basis.
Outlook On Inflation
Higher cost seeps into the economy: Manufacturing firms polled by RBI reported higher input costs and selling prices in the first quarter of current fiscal. Farm and non-farm input costs rose significantly. Rural wage growth remained moderate while wage growth in the organised sector remained firm.
Retail inflation worrisome: Retail inflation, CPI rose from 4.9 percent in May to 5 percent in June, thanks to higher fuel prices, though food inflation remained muted. Adjusting for the estimated impact of the 7th central pay commission’s house rent allowances (HRA), headline inflation increased from 4.5 percent in May to 4.6 percent in June.
MSP Impact: Government had recently increased the price at which it will purchase crop from farmers, which many had said will have a severe impact on the economy. RBI says that the move will have a direct impact on food inflation and second-round effects on headline inflation. RBI has already accounted for part of the increase in June policy and the remaining has been taken for in the present one. Though RBI remains cautious the action suggests that the MSP impact has been taken in RBI’s calculation in increasing the repo rates.
While not making a material change to its range of inflation projections, the MPC said that it expects inflation at 4.6 percent in Q2, 4.8 percent in H2 of 2018-19, and 5.0 percent in Q1 2019-20.
Other factors such as the possibility of higher oil prices, volatility in global financial markets and rising inflation expectations could also impinge on actual inflation outcomes. In case there is fiscal slippage at the centre and/or state levels, it could have adverse implications for market volatility, crowd out private investment and impact the outlook for inflation.
Outlook on Growth
Growth target maintained: Various data indicators in front of the MPC suggest that economic activity has continued to be strong. Monsoon and higher than expected MSP are expected to boost rural demand by raising farmers’ income. Investment activity remains firm while FDI flows have increased in the recent period. Activity in the manufacturing sector is expected to remain robust in the second quarter as per RBI.
Based on these factors RBI has retained its growth forecast at 7.4 percent for 2018-19 is retained.
Export picks up: Exports, the second engine of growth has picked up in May and June 2018 with an across the board recovery. This is credible as the pickup is in the midst of a trade war that has enveloped the globe. Higher crude oil prices resulted in higher import growth but non-oil imports reduced.
A robust economy: The MPC reports points out that the economy is on a strong ground. Industrial growth, measured by the index of industrial production (IIP), strengthened in April-May 2018 on a y-o-y basis with all sectors of the economy participating in the growth. High-frequency indicators of services activity also increased at a faster pace. Tractor and two-wheeler sales growth accelerated significantly, suggesting strong rural demand.
Outlook on External Factors
Foreign fund outflow slows down: On the financing side, net foreign direct investment (FDI) flows improved significantly in the first two months of 2018-19. RBI points out that the tightening of liquidity conditions in advanced economies and growing protectionism has resulted in a slowing down of outflow. Higher FDI inflow in the first two months of the current fiscal helped the overall situation for the country.
Trade War: The central bank is extra cautious over the ongoing trade war between the USA and rest of the world. Rising trade protectionism poses a grave risk to near-term and long-term global growth prospects by adversely impacting investment, disrupting global supply chains and hampering productivity. To add to that is the geopolitical tensions and elevated oil prices which can result in higher inflation.
Ironically, though the RBI has behaved on expected lines, it has increased interest rates twice while maintaining its ‘neutral’ stance. The market would surely run for cover when the stance changes to ‘bearish’.
Sectors expected to be impacted the most
Housing Finance Companies are expected to take a hit due to the already compressed NIMs weighing on account of the intense competition in the HFC Market. Also Infra companies primarily dependant on market borrowings & term loans from banks are expected to bleed as their margins are already low.