Low inflation leads to RBI dovish tone
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In April, when the monetary policy committee (MPC) last met, it surprised everyone with its hawkish tone. It flagged the risk of higher inflation due to the impending introduction of the goods and services tax (GST) nationwide, and also the possibility of a weaker monsoon. The MPC then had turned abruptly neutral (or even hawkish), when instead the market was expecting it to continue its accommodative stance. Its surprise change in stance even triggered discussion about whether we should be bracing ourselves for a rate hike.
But then fresh data poured in. The economy was much weaker than assumed. The last quarter growth in FY17 of gross value added (GVA) was only 5.6%. This meant that for five successive quarters growth has declined steadily from a high of 8.7% during last quarter of FY15 to a low of 5.6 now. It might drop further. The GVA in manufacturing growth dropped by 2.5% from the first to the second half of the last fiscal.
Demonetisation had an adverse impact as was confirmed by data. Private investment spending also is very sluggish. The data on capital formation is also grim. For five years in a row, the investment to GDP ratio, i.e. the gross fixed capital formation, has been declining. We already knew that bank credit to industry was at multi-decadal low growth.
Surely reducing interest rates will have a role to play in reviving weak industrial growth? But the MPC’s mandate is to focus on inflation, not growth. Two months ago the Reserve Bank of India (RBI) was expecting prices to harden, and inflation to become broad based. Here too, the data turned out to be much milder than feared by RBI or MPC. The month-end consumer price index (CPI)-based inflation in March was below 4%, and in April was below 3%. It seems clear that the RBI has been consistently overestimating inflation.
For the past three fiscal years, the projections made for end-of-year inflation have turned out to be too high. India’s inflation has come down from 9.5% to 4.5% in the past three years. That disinflation has been broad-based has been helped by reduction in oil prices, but bulk of it has come from disinflation in vegetables, pulses, milk i.e. food items.
Even the current dip in CPI inflation down to 2.99% is due to vegetables. Despite these actual data numbers, RBI’s inflation expectations survey among households, continue to show stubbornly high levels. Thankfully the survey doesn’t report expectation of 12% anymore, and is in single digits now. Maybe it takes a decade of disinflation to really break the back of inflationary expectations to be better aligned to actual data. But surely the MPC should not be only guided by household surveys.
So the impact of the string of low inflation numbers, and weak data on the economy, is that the language of monetary policy has become somewhat dovish. The RBI’s own inflation forecast has been revised substantially downward. The repo rate was kept unchanged (which was largely expected), but now there is murmur that maybe a rate cut is possible in a few months, as early as August. As such the vote this time was not unanimous (a first for MPC), so one suspects that one vote went for a rate cut. (Clearly there was no case for a rate hike).
RBI has some reason to rejoice that monetary transmission is working much better than in previous years. This could be partly because of the regime of marginal cost-based lending rate that it imposed on the banking system. It is also remarkable that call rates are close to the reverse repo (the lower) rate, despite surplus liquidity.
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So transmission is working not just in deficit conditions but also in surplus conditions. As Aparna Iyer of this paper pointed out, almost Rs4 trillion is parked with RBI. Such is the impact of low credit growth and insipid private sector borrowing. So a focus on reviving growth, within the parameters of flexible inflation targeting, is most appropriate and essential. If affordable housing becomes one of the big growth drivers in the coming years, its kickoff would need rates to be also “affordable”, implying rate cuts this year.
But low inflation surprises can’t get the hawkish gene out of RBI. It has warned about fiscal slippages, made worse now by the epidemic of loan waivers. The health of banking and also continuing saga of bad loans makes revival of credit growth that much harder. Decisions about loan restructuring, haircuts and write-offs need to be insulated from fears of criminal charges of corruption of collusion. That anxiety is sure to slow down the bad-loan resolution process, although the new ordinance and a decisive role for RBI should help. In the months ahead, look for further softening of rates.
Ajit Ranade is chief economist at Aditya Birla Group.