A Committee makes the monetary policy

The medium-term inflation target is set as 4% within a band of +/-2% against 4% by March 2018 before, as the governor clarified this was as per legislative changes


The RBI argued at the conference the appropriate real rate for India has fallen to 1.25%—the target real rate was 1.5-2.0% before— in the global context of falling neutral rates. Photo: Aniruddha Chowdhury/Mint
The RBI argued at the conference the appropriate real rate for India has fallen to 1.25%—the target real rate was 1.5-2.0% before— in the global context of falling neutral rates. Photo: Aniruddha Chowdhury/Mint

The first monetary policy formulation by a committee, instead of just the Reserve Bank of India (RBI), was announced on 4 October. The central bank reduced its policy or repo rate by 25 basis points (bps) to 6.25%. This surprised some as 22 out of 39 economists polled by Bloomberg did not anticipate an interest rate cut. The justification for more easing comes from an improved outlook for food inflation based on kharif sowing and advance predictions of record food grain production. Besides, food inflation momentum has significantly softened. However, the RBI’s inflation-growth projections remained unchanged.

Apart from this 25 bps reduction, there seems implicit space creation for more easing in the future—both the policy statement and the media conference that followed indicate this. The medium-term inflation target is set as 4% within a band of +/-2% against 4% by March 2018 before, as the governor clarified this was as per legislative changes. The RBI also argued at the conference the appropriate real rate for India has fallen to 1.25%—the target real rate was 1.5-2.0% before— in the global context of falling neutral rates. The neutral real rate is the rate that balances desired savings and desired investments, or one where growth is close to potential with stable inflation. Currently this is estimated at close to zero for the US and below zero for the eurozone. The central bank has enormous discretion here, which imparts uncertainty about future policy actions. Left guessing, markets and analysts are bound to speculate.

What about inflation risks? The RBI thinks the downward shift in food inflation momentum, which influences future outcomes, is likely to endure, given the support of supply-management measures by the government. Potential price pressures may arise from increase in house rent allowance (one-off effects not included in the inflation projections) and salary-pension revisions under the seventh pay commission award. No doubt that base effects and food prices will help achieve the 5% target by March 2017, but the RBI’s optimism in achieving the following year’s forecast inflation target of 4.5% is disturbing because of the sticky behaviour of core inflation (excluding food and fuel but including petrol and diesel entrenched in transportation). This component hasn’t really fallen below 4.5% in the past many months. Minus transportation, which reflects retail fuel price changes at pumps, core inflation has never fallen under 5.11% in the last one year; with oil prices in $45-52 per barrel range, this will be a tough battle to win. The services segment is notoriously rigid besides, while household inflation expectations remain elevated.

With this all-round softening, gross value added growth is still predicted to rise to 7.6% as before with balanced risks; it accelerates further to 7.9% in 2017-18. In a nutshell, this seems a Goldilocks setting of low inflation but rising growth.

What will be meaningful is if interest rates soften as much at the ground level, i.e. transmission of the cumulative 175bps of monetary easing through the banking system on to final borrowers. Banks will need to lower deposit rates first. Here, the rapid slowdown in the growth rate of bank deposits - to 7.6% in March 2016 from 10.7% and 13.7% in the preceding two years – is materially significant, just as is the stagnant financial savings of households from 2013-14 at 7.5% of gross national disposable income. In the light of RBI’s past stance, a lower real rate target is puzzling in this context. The view now seems to be that savings will respond more strongly to increases in income instead.

Renu Kohli is a New Delhi based economist.

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