USDINR jumped on growing policy divergence between RBI and Fed

RBI is now effectively treating the +6.00% upper tolerance band of CPI as a target against official +4.00%

USDINR made a fresh lifetime high around 78.27 Monday on growing policy divergence between RBI and Fed coupled with relentless selling by FPIs amid an apparent lack of RBI commitment to its price stability target and defending the currency. For FPIs, higher USDINR is negative for their portfolio value (in USD). Thus, this is a double whammy for FPIs amid negative global cues and higher USDINR; FPIs have turned into consistent sellers of Indian equities.

Although higher USDINR is positive for export-heavy Nifty earnings like RIL, and IT exporters (Infy, TCS, Wipro, etc), pharma-overall it’s negative for the Indian economy and Dalal Street. Also, imported inflation is getting an additional boost due to higher USD and higher global oil. Contrary to popular perception, India’s total trade balance including merchandise and service trade was positive at around $107.40B in FY22. But, in April’22 the net trade balance was -$8.08B against -6.86B a year ago, while in May’22, it was -$14.44B vs +$1.38B (Y/Y). Although at present India’s total trade balance (merchandise + service) is not a cause for alarm, thanks to robust FDI, remittances and comfortable FX reserve, going forward, if global oil continues to stay above $100, it may be a cause of concern.

On 24^th June, RBI Deputy Governor Patra said in a speech titled: Geopolitical Spillovers and the Indian Economy

The Context

The world has been overwhelmed by the fallout of geopolitical conflict, which threatens to snuff out a recovery that was hesitantly and haltingly making its way through multiple waves of the pandemic and multiple mutations of the virus. India’s economic prospects are also challenged by these ongoing developments, and the outlook is darkened and highly uncertain. I thought I would take this opportunity to share with you how the RBI is navigating this tsunami in its endeavor to shield the Indian economy and secure its tryst with a brighter future.

On February 10, 2022, as Governor Shri Shaktikanta Das made his statement on the occasion of the sixth and final meeting of the monetary policy committee (MPC) for the year 2021-22, the mood was one of cautious optimism. In spite of the Omicron-driven third wave, India was decoupling from the rest of the world and fashioning a gradual but strengthening course of recovery. Projections made by the International Monetary Fund (IMF) just a month ago showed India poised to grow at the fastest pace year-on-year among major economies.

In that meeting, the RBI projected real GDP growth at 7.8 percent for 2022-23. CPI inflation was projected to average 4.5 percent, benefiting from the softening of food prices at that time on improving prospects for foodgrains production, the imminent arrival of the winter crop, and strong supply-side interventions. In the words of the Governor, “Our monetary policy would continue to be guided by its primary mandate of price stability over the medium term, while also ensuring a strong and sustained economic recovery… We, in the Reserve Bank, have remained steadfast in our commitment to safeguard trust and confidence in the domestic financial system as we rebuild the foundations of strong and sustainable growth with macroeconomic stability. This has been our anchor in the ocean of uncertainty.”

In a fortnight from then, the world changed. The escalation of geopolitical tensions into war from late February 2022 delivered a brutal blow to the global economy, battered as it had been through 2021 by the pandemic, supply chain and logistics disruptions, elevated inflation, and bouts of financial market turbulence triggered by diverging paths of monetary policy normalization. Since then, the global macroeconomic outlook has become suddenly overcast with the economic costs of the war and retaliatory sanctions.

Emerging markets and developing economies (EMDEs) are bearing the brunt of these geopolitical spillovers as I speak, despite being bystanders. Capital outflows and currency depreciations have tightened external funding conditions, and along with elevated debt levels, put their hesitant and incomplete recoveries in danger. Heightened volatility in financial markets and surges in prices of commodities - especially energy, metals, grain futures, and fertilizers – has accentuated risks to growth, inflation and financial stability.

Like other emerging market economies (EMEs), India to faces major risks, the immediate ones being soaring crude prices and tightening financial conditions. Spillovers in the form of large and sudden swings in financial markets, portfolio capital outflows and supply chain disruptions resulting in shortages of key intermediates, are clouding the outlook. While the external sector is reasonably well-buffered with a high level of reserves and a modest current account deficit, it is prudent to be watchful about the rising intensity and scale of headwinds from the geopolitical conflict which could be overwhelming for all EMEs, including India.

In the next meeting of the MPC in April 2022, Governor’s statement was somber. He termed the war in Europe and its fallout as ‘tectonic shifts’, little realizing that these words would be forerunners to descriptions of the global outlook in terms of extreme weather conditions. In his words, “We are confronted with new but humungous challenges – shortages in key commodities; fractures in the international financial architecture; and fears of de-globalization. Extreme volatility characterizes commodity and financial markets…. the conflict in Europe has the potential to derail the global economy.”

In a span of two months, the projection of real GDP growth was revised downwards by 60 basis points to 7.2 percent for 2022-23 while the CPI inflation projection for the year was raised by 120 basis points to 5.7 percent. These adjustments to the projections can be regarded as the first authentic assessment of the toll that geopolitical spillovers are expected to take on the Indian economy.

By the June 2022 meeting of the MPC, it was clear that risks were materializing faster than anticipated in inflation prints, with three-fourths of the consumer price index (CPI) under siege. In that meeting, therefore, the inflation projection for 2022-23 was raised by another 100 basis points to 6.7 percent.

The State of the Economy

The State of the Economy article published in the RBI’s monthly Bulletin has established its credentials as a reliable and comprehensive source of information and analysis on the Indian economy. In its latest edition, it points out that domestic economic activity has been gaining traction despite the formidable geopolitical headwinds. Gauged from high-frequency indicators, the Indian economy is consolidating its path of recovery. It is heartening that contact-intensive sectors which were hit hard by the pandemic, are regaining traction. E-way bill generation and toll collections indicate a sustained momentum in trade and transport activity. The aviation sector is fast reaching normal levels. Even the automobile industry has recorded recovery across all segments. The labor market is strengthening, but mostly in manufacturing.

Although India’s merchandise exports have stayed above US$ 30 billion over the past 15 months, there has been a moderation in pace in May 2022, reflecting the renewed supply chain disruptions in the wake of the war. Yet, bucking the global decline, India registered robust growth in manufacturing export orders. Import growth is broad-based, taking the trade deficit to its highest monthly level in May 2022, but this is an indication that the recovery in domestic economic activity is gathering strength.

Seen in the broader context of the balance of payments – which is a summary record of all of India’s external transactions – the decline in India’s current account deficit (CAD) to 1.5 percent of GDP in the fourth quarter from 2.6 percent in the third quarter of 2021-22 augurs well for India’s external viability as it is backed by strong merchandise export performance, rising net earnings from computer and business services and a rejuvenation of remittances by overseas Indians from pandemic lows.

On an annual basis, therefore, the CAD turned out to be a modest 1.2 percent of GDP in 2021-22, with the intrinsic strength of India’s foreign exchange earnings mitigating the terms of trade shocks imposed by geopolitical spillovers and the surge in import demand.

With foodgrains production touching a record level for the sixth consecutive year in 2021-22, food security has been bolstered amidst widespread global shortages. As of May 31, 2022, the stock of rice and wheat stood at 3.7 and 4.2 times the quarterly buffer norms. Minimum support prices (MSP) for 14 major Kharif crops for the marketing season of 2022-23 have been announced, but upward revisions have been modest, averaging 6.1 percent, which is a positive for the inflation outlook.

In the industrial sector, the headline manufacturing purchasing managers’ index (PMI) maintained its improvement in May 2022, turning out to be among the highest in the world. While the expansion was led by an increase in factory orders and sales, the increase in input cost pressures remains a point of concern. The PMI services accelerated in May 2022, marking a solid recovery. The business expectations index (BEI) for services expanded for the tenth successive month, but it was also accompanied by large increases in input prices.

Headline CPI inflation moderated to 7.0 percent in May 2022 from 7.8 percent in April, with the easing observed across the board. Core inflation fell sharply to 5.9 percent in May from 7.1 percent in April. For June so far, cereals prices have increased but pulses and edible oil prices have registered a decline. With inflationary pressures from global commodity prices, a number of steps have been taken on the supply side to ease domestic prices. The latest round of the inflation expectations survey (IES) of the Reserve Bank incorporated an extension survey of urban households undertaken after the excise duty cuts on petrol and diesel and the results show a significant moderation in their inflation expectations post the excise duty cut.

The Role of Monetary Policy

It will be remiss of me not to speak about the role of monetary policy in the context of geopolitical spillovers. As a backdrop, it is perhaps useful to summarize the monetary policy actions and stance adopted in 2022-23 so far. Starting in April and up to June, monetary policy has effectively tightened by 130 basis points, which is fully reflected in the movement of the overnight weighted average call money rate, the operating target of monetary policy.

The stance of monetary policy has shifted from being ‘accommodative as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy while ensuring that inflation remains within the target going forward’ to ‘withdrawal of accommodation to ensure that inflation remains within the target going forward while supporting growth.’

With headline inflation having moved up by 80 bps in April but reverting by almost the same magnitude in May, the RBI has surged ahead of the curve. In fact, the question that the now blind-sided are asking is: with prices of food and fuel driving up inflation everywhere and in India as well, how will increases in the policy rate help? This issue has been addressed in some detail in the State of the Economy article, but I will draw out the essence of its argumentation.

The initial shock from food and fuel prices to inflation lies outside the domain of the RBI. Be that as it may, the policy challenge is that food and fuel prices constitute 55 percent of the CPI and the food shock emanates from external sources, in this case, the war in Europe. The sequence from this ‘ground zero’ is that households look at a recent food and fuel prices which are salient items in the average consumption basket and they form their opinions about what inflation would be in the future, say three months or a year from now. If households expect future inflation to go up and stay up, they will adjust their behavior to deal with that situation.

As more and more households and firms increasingly share this view, they will build it into price mark-ups, wage negotiations, rents on houses, transportation costs and the prices of services more generally such as personal services like housekeeping, medical and education fees, entertainment and bus, train and auto fares. With households accounting for close to 60 percent of India’s GDP in the form of private consumption expenditure, this will mean that inflation will become entrenched in the Indian psyche.

As inflation becomes more persistent and generalized as a result, businesses will stop investing because they will worry that demand for their products may get postponed at these elevated levels of prices. Wages and costs will go up, export competitiveness will be damaged and savings in banks will be pulled out and put into gold - that age-old repository of value - which means capital flight from India since 86 percent of gold demand is met from abroad for which foreign exchange has to be paid.

If the RBI does nothing, it will be seen as accommodating the inflation shock, reinforcing the public’s view that inflation may persist, broaden and rise further. On the other hand, if the RBI increases interest rates and tightens monetary and liquidity conditions to make money dearer, it will (a) demonstrate that the RBI cares about people’s expectations and is determined that they should remain hinged – by anchoring people’s faith in the RBI’s commitment to price stability, the foundations of growth will be strengthened; (b) prevent the second-round effects of food and fuel prices, which I just described, from spreading; and (c) deter discretionary spending so that even if people’s spending on food and fuel goes up because of the price shock, they will adjust their expenditure on other items so as not to exceed the family budget. In effect, the RBI’s actions will cause inflation other than that related to food and fuel, or what is called core inflation, to ease and this will bring down headline inflation.

Foreign investors are particularly sensitive to such monetary policy actions. They tend to see them as Indian policy authorities being resolute in their intent to protect the value of Indian assets and so they will not pull out their investments in India. They will, in fact, invest more, with this assurance of the resolve to preserve macroeconomic and financial stability. As capital flows return, depreciation pressure on the rupee that is being experienced now will ease and this, in turn, will curb imported inflation.

The monetary policy action is not without consequences. It will take its toll on spending and demand. That is the price of stability. What the RBI is trying to do is to stabilize the price situation when the economy is able to bear it because, in the longer run, price stability is beneficial for growth. The RBI kept interest rates and liquidity conditions low and easy through all of 2020-21 and 2021-22. As a result, the Indian economy recovered from an unprecedented contraction of 6.6 percent in 2020-21 to a growth rate of 8.7 percent in 2021-22, including an expansion by 4.1 percent in the quarter of January to March 2022 when several advanced and emerging economies either shrank or slowed. In the first quarter of 2022-23, available indicators of economic activity have improved. Unlike the rest of the world, India is recovering and getting resilient and stronger. This is the best time to put the stabilizing effects of monetary policy into action so that the costs to the economy are minimized.

Will these monetary policy actions exorcise inflation? The inflation outlook is tethered to the war in Ukraine. But will we sit on our hands and do nothing in a fatalistic acquiescence? What can monetary policy do? The fact that inflation remains elevated and is broadening indicates that there is some demand that can afford these high prices, perhaps due to revenge spending in a pandemic-stressed response.

The most sluggish part of the index – CPI excluding food, fuel, petrol, diesel, gold, and silver (44 percent versus 47 percent of the CPI in the standard core) – and the weighted median CPI, a statistical measure of core inflation, both showing generalization and momentum. This warrants monetary policy action to ensure demand does not exceed the available supply, even though both are not at full strength.

Another question that has vexed public opinion relates to the RBI’s accountability on monetary policy. The issue has drawn attention in the context of CPI headline inflation has averaged 6.3 percent in the fourth quarter of 2021-22 and projected to average 7.5 percent in the first quarter of 2022-23 and 7.4 percent in the second quarter. Inflation is, however, forecast to edge down to 6.2 percent in the third quarter and to 5.8 percent in the fourth quarter.

The RBI Act mandates that in the case of the inflation target not being met for three consecutive quarters, the RBI shall set out in a report to the Central Government (a) the reasons for failure to achieve the inflation target; (b) remedial actions proposed to be taken; and (c) an estimate of the period within which the inflation target shall be achieved under the timely implementation of proposed remedial actions.

What constitutes failure has been notified by the Central Government in the Official Gazette of India as (a) average inflation is more than the upper tolerance level of the inflation target for any three consecutive quarters, or (b) average inflation being less than the lower tolerance level of the inflation target for any three consecutive quarters.

Let me speak to these issues squarely. Monetary policy is essentially a contract between the sovereign - through its delegated authority, the central bank – and the people. It is an assurance by the sovereign that it will give to the people money they can trust, money that does not lose value or purchasing power, and in fact, stores value into the future. Therefore, it is indeed appropriate that monetary policy is accountable, without any escape clauses.

In India, this accountability is provided for with sufficient flexibility in the form of an inflation target defined in averages rather than as a point; achievement of the target over some time rather than continuously; a reasonably wide tolerance band around the target to accommodate measurement issues, forecast errors and supply shocks; and failure is defined as three consecutive quarters of deviation of inflation from the tolerance band, rather than every deviation from the target.

Let me now turn to the specific aspects of the accountability conditions. Research within the RBI, published in the Report on Currency and Finance 2020-21, and outside it demonstrates that growth is unambiguously impaired when inflation crosses 6 percent. Hence, breaching the appropriate upper tolerance limit of 6 percent for India’s inflation target should trigger accountability if monetary policy has to remain credible.

Currently, we live in extraordinary times. With inflation at multi-decadal highs across advanced and emerging and developing economies, the inflation crisis is global. It is just the face of one of the most severe food and energy crises in recent history that now threatens the most vulnerable across the globe. In response, the most widespread monetary policy tightening in decades is underway. It is the most coordinated tightening cycle in many years, and the actions are appearing synchronized because imported inflation pressures are being exacerbated by country-specific factors acting at the same time.

India is being impacted by the global inflation crisis, reflecting the materializing of geopolitical risks. Although it is largely driven by food and fuel supply disruptions and bottlenecks, mending supply always takes time. Several steps have been taken, demonstrating that price stability is a shared responsibility between the government and the central bank, but these measures will inevitably have gestations: they will show results only over a period. To gain time for supply to respond, monetary policy has to be deployed, but it is not likely to be painless.

As I stated in my minutes in the June 2022 MPC meeting, the accountability mechanism enhances credibility in the monetary policy framework, especially in its commitment to re-align inflation with its target in the event of prolonged divergences and that is of paramount importance. The wide public sensitivity to accountability works in the same direction as monetary policy in the pursuit of ensuring price stability. It shows that inflation expectations are anchored around the conviction that monetary policy will not tolerate persistent deviations from the target because it is enjoined by legislation (not) to do so.

One final question on accountability engages public attention: what is the role of the MPC here? After all, the Act enjoins the RBI – not the MPC - to write the letter on causes, remedial actions, and time to return to target. Will the commitments made by the RBI in the letter render the MPC on auto pilot? Once again, the MPC regulations are unambiguous on this issue. The Secretary to the MPC shall schedule a separate meeting as part of the normal policy process to discuss and draft the report to be sent to the Central Government under the provisions of the Act.

Conclusion

Monetary policy is usually unsung. Whenever risks surround the Indian economy, the RBI rises with everything at its command in defense of the Indian economy. When the danger recedes, the RBI reposes back to anonymity, ready to rise again when the going gets tough.

It may be a premature prognosis, but there are indications that inflation may be peaking. As monetary policy works through into the economy and inflation falls back into the tolerance band by the fourth quarter of 2022-23, it will be the playing out of the baseline scenario. In an alternative simulation which incorporates the policy actions undertaken so far, the easing of inflation could be even sooner and faster. The key is the direction of change in inflation – not its level – in these extraordinary times.

Against this backdrop, we hope that required monetary policy actions in India will be more moderate than elsewhere in the world and that we will be able to bring inflation back to target within two years. If the monsoon brought with it a more benign outlook on food prices, India would have tamed the inflation crisis even earlier.

Without a doubt, the impact of geopolitical risks will cause a very grudging decline in inflation and a possible breach of the accountability criteria, but India would succeed in bending down the future trajectory of inflation, winning the war despite losing the battle. If real GDP growth averages between 6-7 percent of GDP in 2022-23 and 2023-24, the recovery that is increasingly solidifying gets a fair chance of traction. The RBI will have fulfilled its mandate of prioritizing price stability while being mindful of growth.

Conclusions:

RBI Deputy Governor Patra thinks that there are early signs inflation is moderating in India. Thus RBI tightening may be more moderate than Fed. Looking ahead, despite Russia-Ukraine lingering geopolitical tensions and economic sanctions, if Indian real GDP growth averages between 6-7% and inflation between 6-4% in FY23 and FY24, then RBI will have ‘fulfilled its mandate of prioritizing price stability while being mindful of the the the growth’. Thus as per Patra, RBI’s inflation target would be 6-4% rather than 4%. Although, Patra is a known dove in RBI MPC and RBI may also go for another hike in August in line with Fed-RBI may hike +0.50% rather than +0.75%.

As per Patra’s explanation, RBI/Federal government will count price stability mandate failure, if

·         Average inflation (CPI) being more than the upper tolerance level of the inflation target for any three consecutive quarters; i.e. if average CPI is higher than +6.00% for any three consecutive quarters

·         Average inflation being less than the lower tolerance level of the inflation target for any three consecutive quarters; i.e. if average CPI is lower than +2.00% for any three consecutive quarters

In brief, RBI is now effectively treating the +6.00% upper tolerance band (2-6%) of the CPI range as a target rather than 4%, contrary to earlier market perception. RBI, like most other global central banks, has no numerical target of economic growth (GDP), because monetary policies only affect the demand side of the economy unlike fiscal policies, which affect both the supply as-well-as demand side. But like all other global central banks, RBI also has to ensure reasonable economic growth with the given price stability (inflation) target.

Here RBI’s Patra is arguing that RBI’s inflation target will be between 4-6% and real GDP growth within 6-7% on an average. Thus RBI will treat inflation within target once headline CPI falls below +6.00% and further averages between 6.00-4.00% on a durable basis.

RBI was already behind the inflation curve even before COVID and Ukraine was as India’s average CPI was around +6.63% in CY20, +5.14% in CY21, and +6.77% in CY22 (till May). India’s CPI was around +6.01% in January and +6.07% in February, before the Russian invasion of Ukraine. India’s core inflation was also sticky around +6.00% for a long even before the Ukraine war and COVID.

India-headline CPI (Y/Y)

India-Real GDP Growth (y/y)

The Indian economy was already in a stagflation-like scenario even before COVID and Ukraine wars. Indian average sequential CPI (m/m) is now around +0.66%, which is equivalent to +7.86% on an annualized basis, much above even RBI’s upper tolerance band or effective target of +6.00%. All of these are affecting RBI's credibility in maintaining the price stability mandate. The resultant growing policy divergence between RBI (less hawkish approach) and Fed (ultra-hawkish strategy) is causing higher USDINR, higher imported inflation, and also higher bond yields (borrowing costs).

Overall, at a glance Fed may hike +0.75% in July followed by +0.50% each in September, November, and December; i.e. cumulative hike of +3.7% and a terminal rate of +4.00% by Dec’22. Against this likely backdrop, India’s RBI may hike +0.50% in August, +0.35% in September, +0.25% in December, and +0.25% in February for a terminal rate of +6.25% by FY23 (March 23). Thus by Feb’23, the RBI terminal rate may be +6.25% vs Fed’s +4.00% against the pre-2021 status of +4.00% vs +0.25%. Increasing the spread between INR and USD (RBI vs Fed) will support USDINR. Technically, sustaining above 77.50 levels, USDINR may scale 81.75-82.95 by Mar’23.

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