The Reserve Bank of India’s (RBI) monetary policy stance for 2013-14 raises more questions than they answer. The central bank expects baseline gross domestic product growth to increase to 5.7% in 2013-14 from 5% last year while wholesale price inflation is projected in the 5.5% range, a tad lower than the 6% at end-March 2013; the endeavour, it says, is to bring headline inflation down to 5% by March 2014. Against this backdrop, the 25 basis points cut in the repo rate makes sense. What puzzles is the guidance: the balance of risks arising from this inflation growth dynamic leave “little space” for further easing; indeed, the dark picture of inflation and current account deficit risks presented in its macroeconomic assessment the previous day persuaded many in the market to believe that there may be “no space” for easing the next day itself! It was little surprise that stocks fell and yields rose at the inflation-speak, notwithstanding the quarter per cent interest rate cut.
The central bank’s past experience and an increasing role of the Consumer Price Index (CPI) in framing monetary policy may explain this. Rewind to 2009-10 for a limited comparison: Then, core Wholesale Price Index (WPI) inflation remained below 5% until March 2010, headline WPI inflation reached double digits the same month while CPI had been in double digits from July 2009 all this while, reaching 16% in January 2010. The policy rate, in the range of 4.75-5.75%, was obviously aligned to core inflation. Now, in May 2013, core inflation is 3.5% (March), overall WPI at 5.96%, CPI inflation measured by the new index at 10.4% and core CPI, 8.7%. The current policy rate, at 7.25%, remains inside the black box.
What is obvious though is CPI’s movement up the monetary policy radar. This feeds into the central bank’s WPI projections, although WPI has greater weight. Yet the interplay between the two inflation rates remains a mystery; there is little explanation by way of how RBI sees the transmission process from wholesale to retail prices, including lags, in its discussion of the divergence between the two indices. Against the inflation projection of 5-5.5%, the implicit inference is that a normal monsoon, softening core WPI inflation (3.5% in March 2013), weak demand (GDP grew 4.5% in the last quarter of 2012), ongoing fiscal consolidation, benign oil commodities’ outlook, etc., are likely to limit food inflation spillovers into a generalized price increase somewhat; this would be alongside a small acceleration in GDP growth but a still-negative output gap.
To be fair, the huge uncertainty surrounding supply-side factors and the lack of sufficient time series for the new CPI prevents RBI from venturing into CPI forecasts or, for that matter, adopting it as the sole inflation indicator. But the increasing importance of CPI in shaping monetary stance demands harder evidence on relative WPI-CPI roles. The problem doesn’t end here. With households’ inflation expectations guided more by CPI, how does RBI hope to anchor inflation expectations to its target and align these with the policy rate? If WPI inflation turns out to be 5% in March 2014 in line with RBI’s projection, while CPI inflation stays, say at 8% or more, would that render the monetary objective achieved?
There is also the hangover of missing inflation forecasts since 2009-10 as outcomes systematically exceeded targets. The downside is turning out no better: the 6% WPI inflation out-turn this March undershot RBI’s indicative projection of 6.8%. Chances are that RBI will find its projections belied yet again. It may find itself lowering interest rates soon. Hawk-talk may remain, well, hawk talk.
Renu Kohli is a New Delhi-based macroeconomist; she is currently lead economist, DEA-Icrier G-20 research programme and a former staff member of the International Monetary Fund and Reserve Bank of India.