It may be recalled that the April RBI policy had pleasantly surprised the market, insofar that FY19 CPI forecast was brought down. While the reduction in H1 FY19 forecast was understandable given the lower than expected average for Q4 FY18, what was surprising is that even H2 FY19 forecast was reduced to 4.4% from 4.5 – 4.6% earlier, although with a qualifier that risks were tilted to the upside. Indeed, there was a larger list of upside risk factors including a change in output gap assessment and a higher oil price average. Even so, and with focus specifically on CPI ex-HRA, the policy had decidedly imparted a dovish signal to the market, as also evidenced in the substantial fall in bond yields post the event (Please refer “Dovish But Hawkish: The RBI Pleasantly Confuses”, dated 5th April for details).
Given this context, the minutes of the policy threw a hawkish surprise. The two main points that came across were as follows:
1. Concerns with respect to growth that were still evident early in the year, have largely dissipated for all but two members of the MPC. Most notable is the assessment of Deputy Governor Acharya who says : “RBI’s estimates suggest that output gap is closing; the finance-adjusted measure, which I personally prefer, shows near complete closure of the output gap due to the resilient credit growth over the past two quarters”. To be fair, Dr. Acharya has been noting the progress on output gap in previous policy statements as well. However, given that this should be a slow moving variable and one that is at best imperfectly monitored, the pace of change in assessment is somewhat surprising. Thus in the February policy, Dr. Acharya had noted “for a flexible inflation targeting framework, the growth trajectory relative to potential output has to be considered too. On this front, the output gap remains somewhat negative though it has been steadily closing”. He also said : “While RBI growth projections for next year are in line with this buoyant activity of late, the recovery is nevertheless nascent and worthy of some support in the short run”. These seemed to indicate that there may be more time before Dr. Acharya were to substantially change his assessment. And yet in the latest minutes he says: “I have moved substantially closer to switching from the neutral stance to beginning the process of withdrawal of accommodation”.
Now, it can be argued that the Deputy Governor is only expressing an intention and is still willing to wait for more data before he shifts stance. However, one must remember the importance of signaling effect in central bank communication. As far as the evolution of market’s forward expectation and hence its transmission is concerned, an expressed intent for a near term shift in stance is for all practical purposes already a shift to that stance.
2. Almost every member is now concerned with respect to Consumer Price Index (CPI). Even the ultra-dove Dr. Dholakia is acknowledging two-way risks to CPI. Generally, participants seem worried about crude prices, the prospective impact of Minimum Support Price (MSP) hikes, the possible 2nd round effects of state HRA implementation, potential fiscal slippages, survey indicators showing pricing pressures with firms and somewhat higher household inflation expectations. Apart from this, a closing output gap has been highlighted by some members. What is hard to reconcile again is the lower projected CPI trajectory, especially for H2. Thus the same signaling effect as discussed above, was also in play when RBI/MPC marked down their CPI forecasts. The market justifiably thought then that rate hike fears should be pushed back further if the latest available information suggests to RBI / MPC that CPI is likely to average lower than earlier thought.
If looked at from these perspectives, the signaling is significantly different between the RBI policy and the minutes thereof, even though on paper the assessments contained in the two documents may not be as different.
Way Forward
There are decided incremental risks to our macros, some already manifesting and some ahead. We have highlighted some of these recently (please refer “You Want It Darker : A Bond And Macro Update”, dated 18thApril for details). The interpretation thus far was that RBI was largely sanguine as yet given their H2 CPI forecast. However, the minutes indicate that RBI / MPC weren’t focused on the signaling effect of the CPI forecast. Rather, the focus is more on the list of upside factors to CPI in the context of rising comfort with growth. Given the current global backdrop of further firming oil and commodity prices from when the minutes were presumably written, it is quite likely that Dr. Acharya would officially change his stance from ‘neutral’ to ‘withdrawal of accommodation’ in June. Also, it is unlikely that most of the rest of MPC will have too much of a resistance in adopting this stance. This is assuming that there is no dramatic change in the current global backdrop between now and then.
After this, the situation becomes more complex. The first aspect to think about is whether RBI will continue with a neutral liquidity stance once in ‘withdrawal of accommodation’ phase or will it move towards a deficit stance (say 1% of NDTL)? If it is the latter then the current expectations of Open Market Operation (OMO) bond purchases over second half of the year will also need to be revised or abandoned altogether. The second aspect is how soon would the RBI / MPC want to execute the new stance via an actual rate hike? There will be more clarity by August on aspects like the near impact of MSP hikes as well as the monsoons. A lot will depend upon the pace of growth here-on as well. It must be remembered that global data has turned somewhat weaker over Q1. This is currently being considered transitory. However, should it sustain then it would have implications both for our growth as well as for commodity prices. Also, our own local growth drivers have been dented lately with renewed stress on the banking system potentially leading to tighter credit standards. This can also have an effect on our growth momentum. The point is that RBI / MPC’s assessment has been changing quite substantially over short periods of time. To some extent this has to do with the considerable volatility in underlying data and the global macro drop. Thus whatever is being assessed now is certainly not cast in stone. The base case for now, however, is for a change in stance in June followed by the first hike either in August or in October.
From an investor standpoint, the minutes show an earlier change in stance than was earlier envisaged. However, there are two key points that need to be remembered: One, the subsequent cycle is expected to be extremely shallow coming as it does at the mature part of the global growth cycle and at a time when local growth drivers are also far from firmly in place. Two, the front end rates in the bond market are already pricing in almost 75 bps of a rate hike over the course of the year.
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