Pulling up the inflation anchor
The first credit policy coming out after discussions by a new monetary policy committee, and helmed by a new governor, appears to have moved to a flexible inflation target
In this column, on Tuesday, it was argued there was no need for a needless fix like a 25 basis point repo rate cut. But that is exactly what the Reserve Bank of India (RBI) has delivered. That is not the only surprise for those who are batting for the central bank to stay true to the 4% inflation target.
Instead, the first credit policy coming out after discussions by a new monetary policy committee, and helmed by a new governor, appears to have moved to a flexible inflation target.
The decision to reduce the repo rate by 25 basis points was taken unanimously by the six-member monetary policy committee. The accompanying report prepared by its staff (two of them are in the committee, besides the governor) listed a number of upside risks to retail inflation and analysed them. Let us presume that both deputy governor R. Gandhi and executive director in charge of monetary policy Michael Patra endorse the report. The monetary policy committee, too, should ideally endorse the report.
Why cut the policy rate if the journey towards the 4% mandated inflation target will be tumultuous? In the monetary policy report, RBI expects retail inflation to rise to 5.3% by March 2017, which is higher than the earlier stated self-mandate of 5%. Inflation is then expected to ease from there to 4.5% by the end of 2017-18.
Add different shocks to this baseline case and in most scenarios, the retail inflation ranges well above 4% (see Chart of the Day alongside). In fact, the report goes further and says that household inflation expectations have edged up in the latest survey round. Granted that these are adaptive but once the central pay commission recommendations are implemented in totality, it will only fan expectations further. Headline inflation could be 100-150 basis points above the baseline case in 2017-18, warns the report.
The obvious thing to do under such circumstances would have been to hold rates steady. Why the cut, then? The only explanation is that governor Urjit Patel would be willing to tolerate an inflation level of above 5% and even one fleetingly close to 6%. There’s a good reason for that.
Recall the government’s notification of amendment to the RBI’s Act states that “the key advantage of a range around a target is that it allows MPC (monetary policy committee) to recognise the short-run trade-offs between inflation and growth but enables it to pursue the inflation target in long run over the course of business cycle”.
It adds that 4% is the rate to which the monetary policy will return the economy over the medium term, and medium term could be two, three or even five years. Also, headline inflation will need to breach 6% for three consecutive quarters for the government to ask RBI for an explanation. Such an event is unlikely as the central bank or even the non-RBI members of the monetary policy committee would be wise enough to vote for a rate hike by then.
Flexible inflation targeting has given Patel a sweet spot to cut policy rates in his debut monetary policy. It is not a surprise that calls for another rate cut have begun. After all, if the inflation target was seen as 4% (with a deviation of 2% on either side), it is now being seen as a number that will not exceed 6%.