A new era in Indian monetary policy has begun smoothly. The first interest rate decision taken by the monetary policy committee (MPC) was unanimous. All six members voted for a reduction in the benchmark repo rate by 25 basis points. The unanimity was in sharp contrast to the split among economists on what the Reserve Bank of India (RBI) would decide this time around.
There was undoubtedly a strong case for a rate cut before the end of the year. The reason: There is good news on the price front. Inflation will continue to be benign in the months ahead. Food prices are the main reason why price pressures are easing. The daily prices of pulses and vegetables being reported from various markets in the country suggest that the spike in food prices in the four months to July is now behind us. What now needs to be seen is how the easing of food prices translates into lower inflation expectations among households in the months ahead.
There are some grey clouds that cannot be ignored. Core inflation continues to be sticky. Education, medical care and personal services are the main reason why core inflation has been stuck at current levels for more than a year. Rural wages have begun rising once again. The government has increased minimum wages. Inflation expectations picked up in September. The increase in the house rent allowance paid to government employees will push up the consumer price index next year, though the MPC should look beyond this one-time price adjustment when deciding monetary policy.
These challenges cannot be overlooked. Yet, the MPC has done well to focus on the sharp decline in food inflation as the most significant input into the latest policy decision, and the statement from the Indian central bank suggests that the decline in the momentum of food inflation could have deeper reasons than a mere favourable base effect. However, it is also important to note that the MPC has said that there are upside risks to inflation, a view that the RBI made clear in its June and August statements as well.
What now? India has made significant gains in its battle against high inflation over the past three years. The monetary policy report released with the policy statement suggests that RBI economists expect inflation to pick up slightly in the fourth quarter of the current fiscal year, and then come down to 4.5% by March 2018. That means that inflation in the medium term will be close to the central tendency of the target mandated by law. Such a result will be a major boost for an institution whose credibility had been dented by several years of high inflation.
It is possible to roughly calculate from here how much space the Indian central bank has for further monetary easing. It seems to be working with the assumption that the real neutral interest rate in India is 1.25% (and global estimates of the so-called Wicksellian natural rate of interest have been coming down all the way into negative territory because of weak economic growth). So the policy interest rate could be at 5.75% by March 2018, or 50 basis points less than the current repo rate. The upshot: there currently seems to be space for two more rate cuts over the next 18 months.
The new regime at the RBI also seems to be committed to the new liquidity management strategy that Raghuram Rajan introduced in April, when it was decided that the money market should be in neutral rather than deficit mode. The effect of the shift has already been felt in the bond market. Bond yields are at levels not seen since 2009. The Indian central bank has in effect been targeting monetary aggregates in addition to the price of money. Monetary transmission in the financial markets has thus been more effective than in the banking system. The Indian central bank will have to keep pumping liquidity in the months ahead thanks to the festival season, the expected outflow of dollar deposits and the telecom spectrum auctions.
The minutes of the MPC meeting will be made public on 18 October. We hope these minutes provide more than just basic information. The details of the discussion will reveal a lot about how the MPC thinks about the Indian economy. More information about what transpired over the two-day meeting will also help the RBI signal more effectively.