THE GIST of Editorial for UPSC Exams : 01 October 2018 (The case for another interest rate hike)

The case for another interest rate hike

Mains Paper: 3 | Economics 
Prelims level: Monetary policy committee
Mains level: Conservative policy stance will serve India better at this stage.

Context 

• The macroeconomic outlook has changed considerably since the last meeting of the monetary policy committee (MPC) of the Reserve Bank of India (RBI), and so have expectations in financial markets. 
• The majority of analysts now expect the rate-setting committee to raise policy rates largely due to developments on the external front.

Observations made by RBI 

• The MPC is driven by the inflation targeting mandate, renewed weakness in the rupee will affect inflation and inflationary expectations. 
• The crude prices have risen over 12% since the last meeting and are expected to remain elevated in the coming months.
• New forecasts suggest that crude prices could actually rise above $100 per barrel in the foreseeable future. 
• The Organization of the Petroleum Exporting Countries is unwilling to increase production and sanctions on Iran is affecting supplies. 
• Apart from pushing inflation, higher crude prices would further increase the current account deficit (CAD) and put more pressure on the currency.
• Financing the CAD would not be easy in the current global environment. 
• Though the US Federal Reserve is raising rates along expected lines, continued tightening will affect capital flows to emerging market economies. 
• The US central bank is expected to raise interest rates once more this year, followed by three rate hikes next year. 
• Foreign investors have sold Indian assets worth over $11 billion so far this year.

Steps taken by government 

• Several steps taken in recent weeks to attract capital flows and reduce “non-essential” imports.
• It encouraging short-term debt inflows and arbitrarily raising import duty can do more harm than good in the medium term. 
• It is important to highlight that there are no easy short-term solutions to reduce pressure on the external account. 
• The government should focus on removing impediments for reviving exports.
• The depreciation in rupee should help exporters here—but only to an extent given that the data shows that this relationship is somewhat weak in India.
• Further, the newly constituted high-level advisory group would do well to suggest exact policy measures that will help boost exports.
• Higher crude prices will also increase fiscal risks.
• The government has done well to resist the pressure to reduce taxes on fuel products. 
• The central bank should be prepared for possible fiscal slippage. 
• Higher crude prices have complicated India’s macroeconomic management. 
• Also, it comes at a time of tightening global financial conditions.
• The inflation forecast is likely to go up on the back of higher crude prices and a weaker currency.
• A rate hike at this stage would be a prudent response and give confidence to financial markets that the central bank is willing to sacrifice some growth to maintain price and macro stability.
• The increase in CAD and sustained higher core inflation suggest that there is a case for some moderation in demand and, in an election year, monetary policy will have to do a balancing act. 
• This will also help ease pressure on the currency. 

Conclusion 

• A pause at this stage could confuse the market and may lead to greater volatility, particularly in the currency market. 
• Yields on 10-year government bonds have gone up by over 30 basis points since the last policy review. 
• Also, if the MPC decides not to act now, it will have to wait till December to make the next policy move. 
• This could lead to greater uncertainty in the market. Apart from the policy action, financial markets will also closely watch the tone of the policy statement.
• It will be interesting to see if the MPC throws more light on the inflationary impact of currency movement.

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UPSC Prelims Questions: 

Q.1) Which of the following statements is/are correct with respect to Monetary Policy Committee (MPC)?
1. It is constituted by the Reserve Bank of India (RBI).
2. It sets the inflation target to be achieved by RBI.
Select the correct answer using the code given below.
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer:  D

UPSC Mains Questions:
Q.1) Conservative policy stance will serve India better at this stage. Critically examine the statement.