Monetary policy in India has never been as unpredictable as it is now. Not only have we shifted to a radically new committee-led approach, the economy has now been subject to a monetary shock through withdrawal of 86% of its currency in circulation.
There are no ready lessons available to the monetary policy committee (MPC) on how to respond to a monetary shock of this scale. When MPC meets on 6 December, deliberations would centre around the currency withdrawal.
With no precedents, economists are split on whether MPC should announce a rate cut or wait till the entire currency withdrawal plays out by 31 December. But the markets have already taken a cut as granted.
Let us look at the arguments for a rate cut.
Since cash has been snatched away from the public without prior warning, consumption would be hit the hardest. The main engine of growth has suffered and it is but natural that gross domestic product growth will drop in 2016-17. Some like HSBC India and Bank of America Merrill Lynch suggest growth will slip by 0.5-1 percentage points while others such as Ambit Capital Pvt. Ltd warn of a massive drop of 3.3 percentage points.
The cash clean-up has triggered several disinflationary impulses in the economy by hurting both transactions and storage of wealth. The odds of retail inflation falling below 4% in November are high, according to analysts.
These two arguments should give enough firepower to the doves in MPC to push for a rate cut. So if not now, then when?
But in the wake of the monetary shock, it is tempting to get hysterical on growth and this should be avoided. Granted demand has been hit like never before and the timing couldn’t have been worse for the country as it now stands to lose all the benefits of a rural recovery.
But MPC should be data-driven. By waiting until February, the committee will get a clear picture of growth in the third quarter. More importantly, the US Federal Reserve’s rate-setting meet and India’s Union budget (to be announced on 1 February) would also be behind it. The impact of the currency withdrawal on inflation is complex. While the contraction in demand is likely to pull down prices, flare-ups in food inflation are possible, given the instances of stranded trucks and large markets coming to a standstill. Food has the highest weight in retail inflation. Month on month momentum of core inflation has not slowed. Other variables like a pickup in rate transmission by banks, and the impact of currency purge on liquidity are at play too.
The bottom line for MPC is time. How it responds will depend on how fast the economy is re-monetized. After all, time is money. And for India right now, time is also the biggest risk to money. MPC would do well to avoid gambling on this risk.