Fed & flows, not inflation, may be at the heart of MPC debate

The Reserve

‘s slower interest rate increase of 50 basis points compared with the US Federal Reserve’s 75 basis points was guided by the inflation target and actual inflation as well as the need to nurture the economic recovery. A basis point is 0.01 percentage point.

India outperformed most emerging markets not only because of domestic policies but was also helped by capital flows that were chasing returns when rates in developed markets fell to zero or even negative in some countries. The return equation has since changed.

The Monetary Policy Committee (MPC), which fine-tuned its actions based on domestic inflation as well as the need to bolster growth, may have to weigh the emerging dynamics of Fed chairman Jerome Powell’s ‘whatever-it-takes approach’ to get inflation back to 2%.

Capital flows aren’t going to be the same as the theory of the Fed reversing its tightening to counter a recession goes out the window. The yield on two-year US treasuries is at 4.2%, making it the best risk-free investment thesis for global investors who need to factor in currency depreciation while investing in emerging markets. The rupee is down 8.2% for the year.

The mispricing and overvaluation of Indian financial assets – be it equities, bonds or currency – are also a deterrent for international investors whose dollars are necessary to fund the widening current account deficit (CAD), the excess of imports over exports.

At the current rate, India’s balance of payments is likely to be a record deficit of more than $40 billion, which will have a direct bearing on the currency. While it may not be the MPC’s mandate to look at the rupee value, its action or inaction will affect it.

India may have to rein in the CAD even if it means sacrificing growth. The MPC may have to vote for a 60 bps increase in the repo rate to take it to 6% as financial stability calls for actions to deal with capital flows as well.

The rupee hit a record low of 81.24 to the dollar on Friday. The RBI had intervened to defend the 80 levels, but the tide now is so strong that interventions could be wasted ammunition as already shown. The currency buffer is down nearly $100 billion from the peak, reducing firepower.

“The extent of losses the RBI has experienced in terms of spot reserves and its forward book means it has already expended the advantage gained from its strong starting point,” said Rahul Bajoria, economist at Barclays.

“The vulnerability to any increase in commodity prices or much stronger growth, especially from an external balance-sheet perspective, has increased, not fallen. This effectively means that India’s policymakers are likely to be more cognisant of these thinning buffers.”

Easing commodity prices, especially that of crude oil, is a comforting factor. But strong growth itself could become a disadvantage to overall financial stability as low rates fuel import demand as companies expand capacities.

The threat from the Federal Reserve’s quantitative tightening hasn’t escaped the debate at the MPC either.

“Each country is on its own… match the Fed or face currency depreciation, imported inflation, wider current account imbalances, capital outflows and reserve losses,” RBI deputy governor Michael Patra was cited as saying in the minutes of the last MPC meeting.

The Fed and financial markets may have to replace domestic inflation factors as the dominant theme of the MPC deliberations on September 28-30.