Is the Reserve Bank of India (RBI) making a policy error?
Also published on Bloomberg, October 5, 2018
- On October 5, the MPC decided to keep its policy rates on hold but changed its stance from neutral to calibrated tightening. This call certainly was a surprising one, as markets and economists were expecting a 25bps rate hike. Markets have reacted fiercely with the INR sliding further and the Nifty taking a beating
- The MPC defended its choice by emphasising the inflation targeting mandate of the RBI. Against the backdrop of a worsening current account deficit, surging oil prices, weakening INR, a continuing tightening path of the Fed and markets suffering from high anxiety, we feel that this view of the RBI can be considered too narrow
- Moreover, we believe the RBI is underestimating the inflationary pressure in the Indian economy and the impact of ongoing Fed tightening, which will continue beyond this year
- Ultimately, we believe the INR is making a policy error, which has implications for our INR forecast. We hold on to our view that the INR rate ultimately has too return to its fundamentals (of approximately 68), but the trajectory towards this rate will take much longer and will be more painful than we initially anticipated
RBI keeps rates on hold
Today, the Monetary Policy Committee (MPC) gave its fourth monetary policy statement for the fiscal year 2018/19. The MPC decided to keep rates on hold but changed its stance from neutral to calibrated tightening. This call certainly was a surprising one, as markets and economists were expecting a 25bps rate hike. The MPC defended its choice by emphasising the inflation targeting mandate of the RBI. This implies that the MPC will only look at the inflationary consequence of the sliding INR and will be very reluctant to use rate hikes just for the sake of steering the currency.
In addition, the RBI stated that today’s decision is appropriate, given their inflation and economic growth forecasts and the financial conditions. Moreover, the RBI even tuned down their inflation forecasts somewhat and governor Patel hinted that it has already has taken sufficient measures to tame inflationary risks, pointing at the back-to-back rate hikes in June and August, the changed policy stance, and the fact that rate cuts currently are off the table.
Taking a gamble
Against the backdrop of a worsening current account deficit, surging oil prices, weakening INR, a continuing tightening path of the Fed and markets suffering from high anxiety, the view of the RBI to mainly focus on its 4% medium-term inflationary target might be considered narrow and prone to policy errors. The markets are obviously taking a broader view and responded fiercely. INR/USD shortly breached 74 and the Nifty lost 2% (figure 1).
Moreover, if we solely look at inflation projections, the RBI has no crystal ball either and Governor Patel himself underlined that the risks are currently tilted to the upside (figure 2). Sure, food prices are expected to remain benign, but core inflation of 6% is stubbornly high and Brent has hit 85 USD/bbl. It is well-known that India - as the largest net oil importer of all emerging markets - is feeling the pain of higher fuel prices. As a reminder, fuel price inflation rose by 8% in June and 8.5% in August. And there is more: inflation can be pushed higher by domestic factors (the output gap has closed and is moving in positive territory now), the unfavourable monsoon distribution, and higher minimum support prices for crops which the government announced in July. Most ironic, the RBI’s decision to leave rates on hold may have deteriorated the inflation trajectory by spooking the market as the current INR depreciation will result in higher import inflation as well. There is no evidence to suggest that the exchange rate pass-through to Indian domestic inflation has suddenly ceased to exist. According to our calculations, INR weakness since April has, and will, push inflation upwards by 0.6 to 0.8ppts and today’s call will certainly add a few tenths of ppts to that.
A game of Mastermind
Besides the surprise move of the MPC today, we are also completely left in the dark as far as the MPC’s expected 2019 trajectory is concerned. In that sense, the dynamics between the MPC and the market increasingly starts to resemble a game of Mastermind. I’m not referring to the intelligence of Governor Patel or any of the other MPC members here, but the classic code-breaking game that many of us played as kids. For those unfamiliar with the board game, Mastermind involves one player as codemaker (i.e. the MPC), and the other as codebreaker (i.e. financial markets and economists). The codemaker chooses a pattern of four colour pegs (i.e. the policy rate trajectory) and the codebreaker tries to guess the pattern, in both order and color, within ten turns.
In order to win the game as codebreaker, two elements are crucial. First of all, one needs the proper strategy and read the mind of the codemaker to discover certain patterns: does he/she favour the red (bearish) or green (bullish) pegs?, does he/she use multiple colour pegs (single hikes/cuts) or duplicates (back-to-back hikes, status quo), etc.? Second, one requires, of course, a little bit of luck. If both aspects come together, then sometimes a game is already settled within one turn. Today, we obviously missed our turn.
Tracing back the forecasting history
To show just how much the current call of the RBI is surprising, take a look at the evolution of policy rate forecasting in a Bloomberg survey since last year (figure 3). Up till today, our November 2017 forecast was in line with the trajectory of the RBI, although admittedly we have revised our colour combinations a few times since November and now. Consensus also predicted the individuals colour pegs correctly prior to each MPC meeting, although it is fair to say that a couple of more turns were needed (see light blue, pink dots and yellow dots). What we want to illustrate here is that markets and economists were just getting the hang of the way the MPC is playing Mastermind, but today’s call seriously disrupts that pattern and could take market trust back to square one. Keep in mind that this is not the first time that MPC has been surprising the market.
The Fed is spoiling the game
So what can we expect going forward? As always, the MPC kept their cards (or pegs) close to their chest and did not say anything about their expected future rate trajectory. In that sense, playing a game of Mastermind with the RBI is much harder than playing it with the European Central Bank (ECB) or the US Federal Reserve. The Federal Open Market Committee (FOMC) of the Fed publishes a DOT plot which reveals the colour combination it has in mind before a game has even begun. Besides a hike in December, the FOMC shows a median expectation of three hikes in 2019,which would take the Fed’s target range up from 2.25% at this moment to 3.25% ultimo 2019. Now the tricky part here is that markets and economists do not always concur with the colour combination that the FOMC has in mind. In fact, we argue that if the Fed does raise rates three times next year, it might invert the yield curve and the inversion of the yield curve has been a good predictor of recessions within 12 to 17 months. The market also doesn’t fully copy the colour combination of the Fed as well and expects a policy rate of 2.85% at the end of 2019.
The uncertainty about the Fed’s fund rate trajectory might explain why Patel and his fellow MPC members are reluctant to show their projected policy rate for 2019. One has to keep in mind that Fed chairman Powell is able to change the colour combination of the MPC after each FOMC meeting. Now, if the market finds out that Governor Patel has been switching pegs during a game, they might consider that cheating and refuse to play anymore. Today’s sell-off is a good example of how that might play out. Ultimately, if the Fed does continue along their projected tightening path, we can definitely expect another round of stress in the emerging market FX space, which would definitely require a fierce response from policymakers, and definitely a more powerful one than we have seen today.
So where does that leave us with the INR? Last week, we pushed out several reports predicting an appreciation vis-à-vis the USD. But this trajectory did not take into account major policy errors, such as we have seen today. We hold on to our view that the INR rate ultimately has too return to its fundamentals (of approximately 68), but the trajectory towards this rate will take much longer and more painful than we initially anticipated (figure 4).