The Start of a Shallow Interest Rate Increase

A tighter monetary policy was no doubt round-the-corner in India with an increase in inflationary pressures.

5 min read

The Reserve Bank of India raised the repo rate by 25 basis points in a unanimous decision. Unlike for Indonesia, we think that the rationale for the tightening by the RBI seems to be predominantly determined by the outlook on inflation rather than financial stability.

The RBI expressed caution on the rise in the household inflation expectations that can potentially feed into inflationary pressures. With the ‘neutral’ stance preserved, RBI will have the flexibility for future actions, dependent on data flows. The base case is for the RBI to hike one more time in 2018, though the timing can be a bit uncertain.

A tighter monetary policy was no doubt round the corner in India with an increase in inflationary pressures. The pressure had also increased with Indonesia surprising with an out-of-policy hike.


This is because the macroeconomic landscape for both the countries is not too different and both economies were classified within the 'Fragile Five' in 2013. Indonesia acted on its vow to be ahead of the curve with its monetary policy and also probably wanted to pre-empt a probable tightening by the US Fed on 14 June.

Interestingly, the Indonesian Consumer Price Index was on a sideways trajectory with the latest reading being 3.4 percent and firmly within the target band of 2.5-4.5 percent. Core CPI in Indonesia was on a downward trajectory with the latest figure at 2.7 percent. Thus, inflation was never the critical worry in Indonesia and the pre-emptive move could have been targeted to prevent foreigners from selling on both the debt and equity markets.

A few of the above conditions were also becoming evident in India. India’s external balances were worsening for some time with the rise in global crude oil prices. This and tighter global monetary policy conditions were leading to foreign portfolio investors selling in the government securities market, that also led to rupee depreciation of around 5.5 percent from January 2018 till date. Therefore, the critical question, was the basis of the rate increase the emerging risk to financial stability in India? Probably not, as the firepower with the RBI to fight such outflows are much higher than Indonesia.

The RBI has a foreign exchange reserves war-chest of around $415 billion compared to the Bank Indonesia’s $125 billion. 

Thus, it appears that the RBI decision was crucially dependent on its view on inflation and the risks it sees to the same.

What appears to have put the MPC in a corner is the sharp increase shown by the latest round of household inflation expectations that indicated a rise of 90 basis points and 130 basis points rise respectively for 3-month and 1-year horizons. Rising inflation expectations provide the risk of feeding into wages and costs in the coming months and thereby starting off a self-fulfilling cycle.

Manufacturing firms also reported input price pressures and increases in the selling prices in Q1FY19. Input cost pressures were also evident for farm inputs and other industrial raw materials. Added to this, the MPC now sees that the output gap has mostly closed.

Thus, inflationary pressures are seen both from the demand as also the supply sides of the economy.

RBI Deputy Governor Viral Acharya alluded to a “compositional shift” in inflation. While summer months generally see an uptick in vegetable prices, that's not been the case this year. However, there has been a sudden rise in CPI excluding food and fuel and this can be worrying. Our own estimates indicate that core CPI could remain sticky at the higher end through most of FY19.


The RBI may miss its 4 percent target for headline CPI in the event that food prices were to perk up, either because of some adverse monsoon trends – as of now the belief is for a good monsoon – or a sharp rise in the minimum support price, after the government announced that the Kharif MSP increase this year will be according to a new formula of 50 percent over cost of production.

From a credibility point of view, and to restore the confidence of external investors, there was little reason for the RBI to push the rate increase to further down the road. These are probably the factors that played in the minds of the MPC members to have voted unanimously for a rate increase – a sharp turn from just two months ago when only one member had voted for a rise.

What Next From the RBI?

The outlook for inflation has been upped, especially for the second half of FY19 – by 30 basis points compared to the previous estimate. With MSP increases still not factored in, the acceleration of inflation in the second half can be more.

So there is confidence in pointing out that this hike was not the only one in this cycle.

However, the RBI has exercised caution and has kept the stance neutral lest it signals a sharp interest rate increase that could run a risk of throttling the nascent recovery process. The neutral stance also allows RBI to remain extremely data-driven and thus fine-tune its rate decisions given a large number of uncertainties – both domestic and global.


Given the uncertainties, it becomes difficult to gauge the RBI’s next move. My bet is for the RBI to increase at least one more time in 2018, and a maximum of two times. In terms of timing, I think that in the event of oil and the rupee remaining more or less at the current levels and with monsoons not playing truant, the RBI would be willing to skip any rate decision in August and shift any further tightening to October.

While the RBI has allowed for mark-to-market losses on bonds to be spread over few quarters, banks’ profit and loss accounts could still suffer by the new valuation norms for state development loans.

As a result, the demand for government securities from the banking sector could continue to stay weak. The counter-balance can come with more open market operations from the RBI in the wake of its foreign exchange interventions and its efforts to counter the large increase in the currency-in-circulation.

I see the 10-year yield to be in a range of 7.60-8.10 percent in the remaining part of the year, though the risks of a rise beyond 8.10 percent cannot be totally ruled out.

The 10-year benchmark government bond yield had anyway been on an uptrend with expectations of tightening by the RBI. It now quotes at nearly 8 percent and may move beyond that.

A tighter monetary policy was no doubt round-the-corner in India with an increase in inflationary pressures.

For the rupee, the range could be at 66.50-68.50 for the remaining part of the year given a return of the weakening bias for the dollar. This is as the political risks for Europe have largely dissipated for now and the focus could come back to the structural problems that currently haunt the US economy.


(Indranil Pan is Group Chief Economist at IDFC Bank. The views expressed here are those of the author’s and do not necessarily represent the views of The Quint or its editorial team)

(This article was first published on BloombergQuint)

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