Monetary policy in the shadow of polls

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Implementing inflation targeting well can be challenging in an emerging market. Flexibility is essential for good policy, so is good timing. A related key issue is the quantum of adjustment. The MPC took the correct call in cutting rates last time since both inflation and growth have softened further. They are still below MPC forecasts, however, indicating more action is required — but how much and when?

The RBI targets headline CPI inflation, which at 2 per cent is touching the bottom of its targeting band. Core inflation is higher at above 5 per cent, but also within the targeting band. There is evidence that the core inflation converges to headline when there is a sharp fall in commodity prices, since household inflation expectations fall most with commodity prices and overtime reduce the core.

For example, the core was sticky at about 8 per cent in the initial period of inflation targeting. But following the steep reduction in oil prices in end 2014 it had fallen to 4 per cent by January 2015. It rose somewhat again, with the headline, but the rise was not commensurate, suggesting some anchoring of household inflation expectations.

After the end 2018 softening of oil prices, core inflation has begun to fall again. It is necessary to allow for the possibility that the economy has changed. Structural food surpluses, oil political economy and factors reducing costs may keep inflation low. Even the rise in MSP has not been able to raise food inflation.

Both core and headline inflation, therefore, are expected to stay below 4 per cent, while headline will be closer to 3 per cent through 2019. This implies a real rate of about 3 per cent, much above the neutral rate (1-1.5 per cent) and continuing at this level since November.

There is a fear of a possible repeat of the Q2 2015 experience of collapse in private investment after it rose briefly in 2014. This happened before demonetisation. Policy rates were not cut adequately after the 2014 fall in oil prices keeping real rates at 3-4 per cent.

While CPI is relevant for consumers, producer prices which are relevant for the real interest rate that enters firms’ decision-making were and are even lower.

Although national account statistics show investment growth was sustained in Q3 October-December 2018 it is alarming that January IIP capital goods growth fell sharply turning negative. Other high frequency indicators as well as projects in the pipeline also show softening.

That households’ inflation expectations fall with commodity prices also implies there is no excess demand. As a demand squeeze has more effect on output than it does on inflation, there is a high output cost of increasing the output gap to fight inflation. Anchoring inflation expectations through communications is more effective. Forecasts affect expectations.

India has a mixture of backward and forward looking behaviour. Investment is forward looking and an impact on private investment sentiment can cut through lags in monetary transmission. So announcing the path is important but lags imply it is also necessary to start early.

In classical inflation targeting the policy rate is required to be reduced in response to a temporary demand shock and there is an output cost in not responding to temporary fall in costs. Early it took a structural rather than a counter-cyclical view but now that inflation is within the band, there is no reason to neglect the growth cycle.

The first rate cut should have come in December. Because of the late start, a 0.5 percentage point cut is warranted to support a likely investment push after the election results in May if there is a stable government in place and mitigate the downturn if there is not.

Markets widely expect a softening because of the growth slowdown, and see room for at least two cuts. In thin markets the effect of a policy rate change is low, so a large change is required. After the global financial crisis it was slashed excessively by almost 3 per cent.

Today there is greater market development, but a baby step of 25 basis points may still be inadequate. A middling change would be appropriate now. There is virtue in frontloading cuts. The stance must change from neutral to accommodative so that future rate cuts are factored into decision-making.

The RBI will not be seen as bowing to government pressure since the cuts will benefit the next government, not this one.

The transmission

It is often argued there is no point in cutting rates since transmission is inadequate. But market borrowings, which are more affected by policy rates, now have a larger share. In banks pass through is higher if durable or long-term liquidity is in surplus. They do not like to lend long on the basis of short-term money market borrowing.

Currently deposit growth is slow but over time credit creates deposits. When durable liquidity is tight, informal rates rise, leading to further leakage of currency and reduced deposit growth. The liquidity situation has improved since February. But there is cash leakage also due to elections, so maintaining a surplus in durable liquidity will help transmission. Elections tend to increase spending by political parties but the short window announced will end in May. Since food inflation continues to be low the spending will not be inflationary.

There is movement in settling broken credit delivery mechanisms with further bank recapitalisation and more banks moving out of prompt corrective action. NBFCs’ loan growth has reduced, but bank lending to them and to industry has increased in a move to a healthier balance. There is scope to further reduce some regulatory weights.

Since credit growth is higher (15 per cent), rates at which it is available matter and would increase it further — interest elasticities are high for consumer durables and housing and therefore for investment.

External risks

There is some improvement in the global picture, but it is still mixed and a slowdown is expected, so sustaining domestic demand is important — especially since dependence on commodity imports limits depreciation in India. Without global or domestic demand production capacity decays, as happened since 2011. As a result imports became more diversified.

The slowdown, along with other factors, is likely to keep oil prices soft. With better pass through and renewable energy initiatives India’s oil intensity has been falling since 2005. The current account deficit is reducing. Financing this reduced deficit is no longer a problem. Moreover, foreign portfolio flows to emerging markets have revived.

Much is made of the crowding out of private investment and risks to the current account deficit because public sector borrowing requirement (9 per cent) exceeds household financial savings (7 per cent). But this argument neglects the large rise in savings of private non-financial corporations to above 11 per cent of gross national income.

So there is no crowding out. PSUs were asked to expand borrowing since credit growth to private industry was negative, and will retreat as the latter revives. Expenditure on roads and housing has kept the economy going. Since fiscal space is less, however, the onus is on monetary policy. Over-strictness in monetary policy and the slow growth it engenders also creates risks.

The writer is Professor, IGIDR, and Member EAC-PM

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