Higher interest rates are here to stay: Business Line 2nd August 2018

RBI’s thrust on price control could mean policy rate hikes each time inflation threatens to cross the 5 per cent mark

With the credit policy of the RBI being announced six times a year, the expectations are that the action to be taken would be based on precedent. One tends to look back at the language of the earlier policy and then juxtapose the developments that have taken place on the revealed concerns of the central bank and then make conjectures on what the RBI would do.

The decision, however, is of the Monetary Policy Committee (MPC) and hence the majority view is supposed to be based on similar rationale. Based on what the RBI had projected in the earlier policy, one could have expected the committee to wait for more data points before taking a call. However, the majority decision was to hike rates.

How should we look at this rate hike? Inflation is the main factor that is being targeted by the MPC and logically the future path becomes important. In the statement, the RBI says clearly that it still expects inflation to be less than 5 per cent this year. It has been put at 4.6 per cent for Q2 and 4.8 per cent in H2-FY19.

With the last inflation point at 5 per cent, these numbers look to mean moderation going forward. Yet the decision is to increase rates means that the intent is to keep the inflation rate below 5 per cent mark at all times. As a corollary, it can be said that whenever the rate looks to cross 5 per cent, we can expect rate hikes.

Inflation triggers

Now let us look at the factors that are causing concern. The MSP (minimum support price), combined with the monsoon, is the leading factor. Now the MSP story may be overstated by economists because even though MSPs have been hiked in the past they have not lead to inflation.

In fact, for pulses and oilseeds, MSPs have increased by around 5 per cent in the last couple of years but prices have actually come down. The reason is that when there is no procurement, the MSP becomes less credible. Therefore, it can be reasoned that farm prices causing inflation would be more when the crop fails or where procurement is active like in the case of rice and cotton.

The other factors such as HRA and oil prices are known concerns, which will play out either statistically or by global actions.

For the latter, it looks like there would be stability till the next policy. The government has taken a major step in lowering the GST rates, which should help lower prices on the manufacturing side.

This component had contributed to the over 6 per cent core inflation in the last few months. While the action of the RBI is justified, it will be interesting to see whether or not inflation will remain below the 5 per cent mark.

The RBI has also mentioned a neutral stance with the rate hike. This should be taken to mean that it would ensure that liquidity is available to the market and should not be a limiting factor.

This should assuage the market as lack of liquidity can cause a spike in rates which, the tone suggests, will not happen. So one can expect more OMO (open market operation) purchases during the year when required.

Will interest rates go up? It has been seen in the past that when the RBI lowers rates, deposit rates move down but lending rates remain sticky. The reverse holds when the rates are increased, where MCLRs and the base rate will go up while deposit rates would trail.

As bank credit growth is expected to revive this year with industry showing signs of a pick-up, it may be expected that the cost of credit would increase.

Normally borrowers tend to look at both the loan and bond markets for the best terms of borrowing. In a rising interest rate scenario, corporate bonds and CPs (commercial papers) would react faster, which means bank credit may be preferred. This was already observed after the June policy, when borrowers switched back to banks. This would be good news for banks though cherry-picking the projects will become crucial.

More rate hikes?

Will there be more rate hikes? The answer looks to be almost certainly yes, if the inflation number crosses the 5 per cent mark and, hence, the outlook on the monsoon and kharif crop will hold the key to this decision.

The sowing pattern so far has been slightly disappointing for some crops like pulses and oilseeds.

Low prices in the last two years could have caused either a migration to other crops or lower sowing to keep prices at more reasonable levels.

This can be a potential pain point in the next few months, which will be monitored by the RBI closely.

How about growth? The RBI has not changed its growth forecast and this means that notwithstanding the rather good growth numbers seen in IIP and core sector in the first few months of the year, the growth path will remain at around 7.4 per cent. While this is assuring, it also means that the country has to wait for another year or so before crossing the 8 per cent threshold which was last witnessed in FY16.

The RBI action is hard to conjecture as the futuristic view taken can provoke a differentiated response on different occasions. But, for sure, it can be said that higher rates are here to stay.

This can be the message taken from the rate action with another one on the cards, though the timing will be uncertain.