New Delhi: Central banks regularly face the task of making decisions in the absence of complete certainty. However, occasionally, several risks will converge within a short time frame, giving policy-makers a very narrow road to travel. The week might be one such moment for India’s central bank.
The Reserve Bank of India’s Monetary Policy Committee (MPC) is expected to make another policy decision on June 5, with the analysts, investors and businesses on the lookout for any hints from the central bank on its course of action amid the volatile external scenario. The last few weeks have transformed the scene considerably, with a majority of economists still predicting the RBI would keep the repo rate unchanged at 5.25%, but that doesn’t seem to be the case. A Reuters poll showed nearly 80% of economists were predicting a rate-hike status quo, with many now seeing a rate hike later this year if inflationary pressures mount.
The main worry is the rising regional tensions in West Asia that have helped drive global crude oil prices significantly higher and put upward pressure on emerging-market currencies. When energy prices increase, they can have a number of effects in India, a country that relies on imports for almost 90% of its crude oil needs, including effects on transport and manufacturing prices and on household inflation.
Meanwhile, the rupee has depreciated considerably against the US dollar, raising another concern. The rupee had fallen to a new low against the dollar in mid-May, but rallied somewhat since then. The rupee has been one of the weakest currencies in the Asia bloc this year despite the recovery, having fallen by about 5%–6% due to oil prices, foreign outflows, and geopolitical uncertainties.
The rupee’s action in recent sessions has sparked a fresh debate over whether the RBI will be more hawkish than anticipated. However, the market’s sensitivity to any indications that policymakers are becoming displeased with the weakness of their currency or with imported inflation has increased.
However, few economists think the central bank will employ interest rates as a direct weapon to support the currency.
Rather, many anticipate the RBI will continue to play the market, resort to liquidity management, and make regulatory tweaks to keep extreme volatility in the foreign exchange market in check. Recently, the Central Bank has carried out spot dollar selling, buying and foreign exchange swaps to stabilise the rupee and in doing so to control the liquidity position in the banking system. Such measures are the latest in RBI’s practice in favour of selective market operations, instead of interest rate hikes with only currency stability in mind.
The current predicament is that the RBI has to balance inflation risk against its growth concerns. An appreciation of the Rupee and higher crude prices would drive imported inflation higher at a time when policymakers have been trying to keep prices under check. Retail inflation was 3.48% in April, well within the RBI’s medium-term inflation band of 4%, though economists have raised concerns that continued energy price rises may drive inflation up in the next few months.
Hence, the wording of the policy statement is perhaps of greater significance to many analysts than the actual rate decision.
No change in rates is largely factored into markets. Investors will be watching for a shift in the RBI’s inflation risk assessment. Several economists have suggested that the central bank will recognize the impact of these price increases, supply-chain problems, and geopolitical uncertainty, and that it will remain flexible about any future steps that may be needed if conditions worsen. Many also foresee larger revisions to inflation forecasts and slight downward revisions to growth forecasts.
This market is already anticipating several scenarios. According to analysts monitoring the policy meeting, the announcements might be as simple as a routine pause that conveys a more measured message, or a sudden rate hike with a more emphatic message to prop up the rupee and keep inflation expectations under control. The latter is still a minority opinion, though. Overall, the sentiment remains that a “hold” decision with a more watchful stance is the best course of action.
The implications for businesses are great.
Firms already grappling with the added costs of currency devaluation and escalating energy costs tied to imported raw materials will likely experience further increases. A weaker rupee can help export-related industries, but if the world economy slows due to geopolitical uncertainty, this benefit can be partially offset. Financial markets, on the other hand, remain highly sensitive to signals about inflation, liquidity, and rate paths.
The change is evident in all asset classes. Bond markets are trying to determine what the RBI’s inflation thinking is, equity investors are assessing how it will affect their bottom lines, and currency traders are looking for any indication of intervention or policy changes. But interest rate swap markets appear to be becoming more complacent about tighter monetary conditions over the next 12 months, even if the June policy decision is unchanged.
What is striking is that the discussion on the policy is not just about pressures from the domestic market. Much of the uncertainty lies abroad in India. The geopolitical uncertainties, oil market fluctuations, and currency shifts have created a situation in which external factors may affect monetary policy decisions more than usual. The threat is heightened by uncertainties about global supply routes and energy supplies, which could be affected by an extended conflict in the region.
With Governor Sanjay Malhotra and the MPC at the helm of the deliberations, it is likely to be a balancing act. The central bank has to calm markets by acknowledging that inflation risks are at hand, but without unnecessarily limiting growth.
So far, most economists are expecting a continuation rather than a surprise. The commentary, however, may be just as influential as the actual policy decision, as crude oil prices are high, the rupee’s value is being tested, and inflation fears are returning. Global uncertainty can affect market sentiment regarding the coming months, so any slight change in tone could be significant.
