Rethinking RBI’s monetary easing policy
By Amarendu Nandy
The latest Index of Industrial Production (IIP) and Consumer Price Index (CPI) numbers are likely to pose a serious dilemma for the Reserve Bank of India’s Monetary Policy Committee (MPC), when it reviews key policy rates in its upcoming meeting on December 3-5. Based on credible signals of an economic slowdown, and RBI’s stated position of an accommodative monetary policy stance in October, many analysts believe a further (repo) rate cut to be a foregone conclusion. The latest retail inflation numbers are likely to make it tricky.
The IIP numbers, released by the Central Statistical Organisation (CSO), showed that factory output declined sharply by 4.3% in September 2019—recording its worst performance in almost eight years, whether computed in the new (base year 2011-12) or the old (base year 2004-05) series. In the April-September period, the cumulative growth in industrial output was only 1.3%, compared to 5.2% in the same period a year ago. The latest decline is broad-based—with a substantial fall in the production of capital goods and consumer durables, and a slump in construction/infrastructure growth.
On the other hand, latest data from the National Statistical Office (NSO) showed that year-on-year CPI inflation was at a 16-month high of 4.62% in October, breaching RBI’s medium-term target of 4% retail inflation. Notably, CPI inflation serves as the nominal anchor in the conduct of monetary policy under the current flexible inflation-targeting (FIT) framework of RBI.
Much will, of course, depend on second-quarter growth numbers, to be released on November 29. Estimates provided by the Japanese brokerage firm Nomura and SBI’s Ecowrap report both project FY20 Q2 GDP growth at 4.2%, substantially lower than the officially reported Q1 GDP growth of 5% in the same fiscal.
The above numbers suggest that we are not only amidst an economic slowdown, but a full-fledged stagflation may potentially be on the horizon. This calls for a careful reflection on what might constitute an appropriate policy mix, including the monetary policy stance, under such circumstances.
In response to a significant economic slowdown, RBI has reduced repo rates five times on a trot—from 6.5% in December 2018 to 5.15% in October 2019—expecting that its transmission to lower interest rates will buttress credit uptake by firms, and kick-start an investment-driven growth cycle in the economy. While central banks in many countries have enacted monetary easing policy in response to the slowdown in domestic and global growth and uncertainties arising out of geopolitical tensions and trade wars, with a 135 bps reduction in repo rates over the past 10 months, RBI’s stance has been the most aggressive among all.
However, in the emerging scenario of rising retail inflation in India, RBI’s monetary easing policy requires a pause. Here’s why.
The latest headline inflation numbers suggest that much of the rise in overall inflation has emanated from food price shocks, with substantial inflation observed in vegetable and pulses (26% and 11.7%, respectively) in October. Measured on a year-on-year basis, vegetable price inflation in urban and rural areas has been 35.4% and 21%, respectively. As surplus rainfall during August and September has severely damaged kharif crops across the key producing states of Rajasthan, Madhya Pradesh, Maharashtra, Gujarat and Karnataka, high food inflation is likely to persist.
The impact of such a supply shock is likely to feed into long-term inflation expectations, with the possibility of core inflation (currently at 3.47%) reverting to (the levels of) headline inflation. An IMF research* shows that, historically, the pass-through from headline to core inflation in India has been rapid—the gap reducing by three-fourths within one year due to significant second-round effects. The share of food in household consumption expenditure continues to be high (30% in 2017-18 as per the NSO). Research shows that high food inflation plays a critical role in informing both inflation expectations and wage-setting in India.
Currently, headline inflation has already breached RBI’s medium-term target. RBI’s September Households’ Inflation Expectations Survey shows three-months and one-year ahead median inflation expectations have hardened to 8% and 8.1%, respectively. This implies that the central bank can ill-afford to lose sight of its core objective of maintaining price stability, a critical element of which entails anchoring long-run inflation expectations. Failure to do so can severely damage the credibility of the central bank, and question its commitment towards the FIT framework.
In addition, it is now clear that despite policy rate cuts, there has been a limited transmission to borrowing rates of corporates. Deposits constitute about four-fifths of total funds of banks, compelling them to offer high deposit rates, thus resulting in a low margin between deposit and lending rates. A reduction in repo rate does little to help the banks’ overall costs of funds, leading to stickiness in lending rates. RBI’s nudge to link retail loans to external benchmarks instead of internal ones based on marginal cost of funds can help improve this situation, but adoption by commercial banks has been predictably slow. In such a scenario, instead of further rate cuts, RBI’s focus needs to shift towards improving transmission efficiency and enacting broader banking-sector reforms—which facilitate greater competition amongst banks to ultimately move towards a repo-linked deposit and lending regime.
The aggressive monetary easing policy of RBI is unlikely to boost investment demand in the economy unless aggregate consumption picks up. With the possibility of stagflation on the horizon, a right mix of fiscal, monetary and supply-side policies is required at this juncture. While the government needs to prioritise job creation and adopt expansionary fiscal policies to trigger a consumption-driven virtuous cycle of growth, RBI needs to focus on price stability. So far, a weak supply-side and fiscal policy response to the current slowdown has disproportionately raised the stakes for monetary policy to lose sight of its core objective of inflation management.
* ‘Food Inflation in India: The Role for Monetary Policy’, by Rahul Anand, Ding Ding and Volodymyr Tulin
The author is an assistant professor, Economics, IIM Ranchi. Views are personal