India’s central bank is getting its way on rates

Back in February, when India was still in denial about its brewing inflation challenge, economists at Nomura Holdings Inc summarised the choices before the monetary authority into three neat boxes. First, they said, there was a 15% probability that the central bank was right to ignore supply-side pressures. But their base case, to which they assigned a 50% likelihood, was that the Reserve Bank of India (RBI) was wrong and it would have to pivot to containing price increases. They did consider a third possibility to which they gave a fairly significant 35% chance: that the RBI, although wrong about inflation, would simply go on to tolerate it.
“This is a scenario of fiscal dominance, in which policy rates rise by much less than we expect in 2022, but macro risks — both inflation and external — could be much higher than our current baseline,” Nomura analysts Sonal Varma and Aurodeep Nandi wrote in a Feb. 25 note. “We see a potential stagflationary outcome in this scenario.”
Fiscal dominance occurs when the government’s finances — for instance, the cost at which it borrows — take priority and force the monetary authority’s hand on interest rates, hurting its power to fight inflation. That isn’t the case in India right now. In early May, when the fiction of transient inflation became impossible to keep up, the Indian central bank surprised the market with an unscheduled 40 basis point increase in the benchmark interest rate. It followed up by raising the policy rate by another 50 basis points, though this time the tightening was widely expected. For now, it doesn’t look like the fiscal authority is keen to dissuade the central bank from doing its job.
At 7.8%, the pace of annual price increases is at an eight-year high and still climbing. In other words, it’s early days in India’s battle against inflation, and the finance ministry might yet lose its nerve if, in the process of containing price pressures, the RBI pushes up bond yields too high, complicating the government’s plan to raise money by selling a record 14.31 trillion rupees ($184 billion) of notes this year.
So far, the administration of Prime Minister Narendra Modi doesn’t seem to be rattled. If anything, New Delhi has announced a $26 billion package, which includes tax cuts on fuel, to help the RBI keep a lid on inflation. That package is unlikely to be a substitute for more rate increases; it might even enlarge the public borrowing plan. To this, add the increase in prices for monsoon-sown crops — including rice — that the government will pay farmers to procure their harvests for public distribution. Money will have to be found for this, too.
RBI Governor Shaktikanta Das has to assure New Delhi that its borrowing program would get completed without pushing the 10-year yield much higher than the current level of around 7.5%, a three-year high. The question is, can Das really hold the line on long-term bond yields? And will the government change its carefree tune if he can’t. Luckily for Das, so far there’s been nothing of the 2015 bluster when, the top bureaucrat in the finance ministry had internally sought an investigation into then Governor Raghuram Rajan’s decision to keep interest rates high, by which he was allegedly helping “the white man” — shorthand for investors in rich nations — at the cost of domestic investment and growth.
After Rajan’s 2016 decision to return to the University of Chicago, the friction carried over to his successor.

—Bloomberg