BackDeciphering Raghuram Rajan’s next move
The decision to cut administered rates will improve monetary transmission but not alter inflation trajectory
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All eyes are on Reserve Bank of India (RBI) governor Raghuram Rajan as he gears up for the first bimonthly monetary policy meeting of FY17. This is scheduled for 5 April, and would be the second meeting in the current calendar year. It would be useful to take stock of the positive and negative factors since the last meeting that are likely to affect the central bank’s actions and guidance.
Local financial markets have priced in a 25 basis points (bps) cut in the repo rate to 6.5% at that meeting. One basis point is one-hundredth of a percentage point. Comments around liquidity management could be constructively reassuring. To be sure, recent inflation data had already made that rate cut quite obvious. The cloud of fiscal-related uncertainty in the run-up to the budget was partly addressed by the government’s intention to stick to fiscal discipline, at least superficially. I use “partly" because the fiscal math is hardly credible (see: Beneath the fiscal facelift, 7 March 2016).
The real essence of the policy meeting will be in the guidance. Here, the RBI’s policy response function would remain data dependent, and the stance will continue to be tactically accommodative. The central bank is unlikely to invite wholesale wrath by indicating that it is done with easing. It is far better off dangling the carrot of potentially more easing, but making it conditional on positive inflation surprises.
It would make sense for Rajan to flag the challenges in ensuring further sustained decline in inflation towards 4% by early 2018, though the 5% mark by March 2017 appears achievable. The inflation guidance of 4% remains very ambitious in the context of recovery in a supply-constrained economy.
Delayed US tightening is welcome, but inflation dynamics remain the key focus in the RBI’s flexible inflation-targeting monetary framework. Here, the data has been encouraging. Consumer price index (CPI) inflation has eased to 5.2% in February, aided mainly by the reversal in the prior spike in the prices of pulses. This trend has more to run and will thus likely push inflation lower in the next few months.
There are two factors regarding the inflation assessment that shouldn’t be ignored. First, firming core inflation, despite the still-weak aggregate demand. Core inflation increased in February to 4.9% year-on-year (y-o-y) compared with 4.7% in January. It was 4.2% in August 2015. This suggests chronic structural demand-supply imbalances in some sectors (healthcare and education, for example) that remain largely unaddressed by the government. Industrial activity remains weak, with production declining 1.5% y-o-y in January. This was the third consecutive decline and underscores the ongoing weak on-the-ground activity that isn’t echoed in the more upbeat gross domestic product/gross value added data.
Second, volatility in food inflation remains a pesky challenge in reliably forecasting the inflation trajectory. It isn’t an exaggeration to write that the margin of error in forecasting India’s inflation is perhaps the highest among Asian countries. This uncertainty, which can only be eliminated by government actions to mitigate the hit from weather-related supply disruptions, has adverse implications for sustained anchoring of inflation expectations.
The RBI will undoubtedly acknowledge the recent, greater-than-expected improvement in CPI inflation. It would, however, be constructive if it also points out that, despite the welcome decline, India’s inflation is the highest in Asia. This high relative inflation has implications for the rupee’s built-in structural depreciation bias.
The RBI should also offer a timely reminder to investors—as it did last year—to not be swayed by the statistical decline in inflation in the next few months. Since the last policy meeting, international crude oil prices have rallied around 20%. This is a reality that the RBI cannot ignore, especially since the rally—following a breather—has more distance to cover. Also, the inflationary impact of the new cesses in the Union budget shouldn’t be dismissed.
Could the superficial fiscal discipline and the recent, long-overdue decision to cut the small savings rate prompt the “reward" of a bigger 50 bps rate cut? Frankly, there is little justification for that unless the RBI meaningfully lowers its inflation forecast of 5% for March 2017. Given the multiple domestic and overseas moving parts, this appears unlikely.
It is important to appreciate that the RBI’s dharma in the new monetary framework is the inflation outlook. The government’s bold decision to cut administered rates will improve monetary transmission, but doesn’t alter the inflation trajectory. And just because financial markets have priced in a 25 bps repo rate cut is no reason to announce a bigger move in order to surprise.
Insufficient concern has been expressed about the budget’s fuzzy math, in my view. This isn’t surprising as the chalta hai attitude—which incidentally contributed to the acceptance of business improprieties that led to some of the asset quality woes in the banking system—is deeply ingrained in our psyche. The Union budget’s fuzzy math can’t—in fact, shouldn’t—be ignored, and Rajan should categorically address this concern. More important for monetary policy is the consolidated (centre plus states) fiscal position. This offers little reason for aggressive monetary easing.
Given the budget’s flaky math, the government’s welcome intention of fiscal discipline should be taken with a bagful of salt. Indeed, Rajan must know that if intentions were horses, politicians would ride them.
Rajeev Malik is a senior economist at CLSA, Singapore. These are his personal views.
Comments are welcome at theirview@livemint.com
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