Public crippling of a key reform

With no time-bound anchor within it, the exceptionally wide 2-6% inflation range makes for a crippled framework

Photo: Bloomberg
Photo: Bloomberg

Members of India’s newly minted monetary policy committee (MPC) have their work cut out for them. In light of the importance of the shift in setting interest rates by the MPC, the policy statement following last week’s rate cut and the post-policy communication left a lot to be desired.

There have been three changes related to the process of setting policy interest rates.

First, the government has a delayed and ambiguous time frame to achieve the inflation target; second, last week’s policy rate was decided by the six-member MPC; and finally, there is a new Reserve Bank of India (RBI) governor.

Monetary policy statements are written to justify and communicate clearly the thought process behind interest rate decisions. The maiden statement of the MPC has at least two glaring oversights, in my view.

First, there is no guidance about the future policy path. Is this a conscious choice by the MPC? If yes, then an explanation is warranted. If no, then why was the guidance skipped?

Second, how does the MPC marry the decision to cut rates with its signal of upside risk to inflation in early 2017?

Frankly, I expected a rate cut this month but anticipated the MPC signalling its comfort in achieving—or even doing better than—the inflation forecast of 5% for early 2017. At one place in the policy statement, the decision to cut rates is qualified as being consistent with achieving the 5% inflation forecast in early 2017, while at another place an upside risk to that inflation forecast is signalled.

The indication in the statement that this upside risk is less than in the previous two policy meetings is bizarre at best—the MPC did not exist prior to this month’s meeting. The fact that it chose to express the upside risk to inflation is itself meaningful. Notably the biannual monetary policy report in April showed an inflation forecast of 5.1% in the first quarter of 2017; this has been revised up to 5.3% this month.

I personally can’t recall a rate cut by any credible MPC while indicating an upside risk to its short-term inflation forecast. The issue here isn’t the accuracy of the inflation forecast but the internal consistency of the action on interest rates and the inflation outlook.

It isn’t clear if the issue of real interest rates was discussed by the MPC—the policy statement doesn’t mention it. However, in the post-policy briefing, it was mentioned (not volunteered but in reply to a question) that it has come down, to around 125 basis points versus the RBI’s prior guidance of 150-200 basis points (one basis point is one-hundredth of a percentage point).

Now, the appropriate level of real interest rates (distinct from but confused with neutral rates) is not cast in stone, but the sudden change in the thought process is significant. Neither the weakness in global growth nor the downward shift in neutral interest rates globally is anything new—it isn’t clear what prompted RBI to signal this shift now and that too in the manner in which it was communicated. Why should another lowering of this guidance, say, next year be ruled out?

To be fair, the most important aspect of the MPC decision doesn’t involve the less-than-effective drafting of the policy statement, or the inexcusably rushed let’s-get-done-with-this briefing by RBI. The crucial aspect is that the MPC has to operate within the mandate given to it. It is here that the government has softened its stand on inflation.

The 4% inflation target (with a range of +/-2%) is now to be achieved over the medium term rather than by early 2018 (announced sufficiently well in advance). One wonders if, as long as inflation is sufficiently below 6% (say, 5-5.3%), the government and the MPC will be broadly sanguine about inflation.

It is disappointing that after having made significant progress in lowering inflation and anchoring expectations towards 4% by early 2018, the government has backtracked on that goal.

Indeed, abandoning the prior time frame only shows that the government isn’t convinced about its own measures to lower trend inflation.

The 4% inflation target to be achieved over the (fuzzy) medium term within the exceptionally wide 2-6% range given to the MPC is almost meaningless, in my view. This is because the range is way too wide, with no near-term, time-bound target anchor within it. Interestingly, the RBI has raised its early 2018 inflation forecast but the MPC has still cut interest rates—abandoning the prior timeline created that room. There is no reason to think the same won’t be repeated as long as inflation is adequately below 6%.

Frankly, the RBI’s inflation forecast of 4.5% (revised up from 4.2%) for early 2018 remains ambitious. However, the government’s backtracking and the new fuzzy timeline offers scope for the MPC to cut interest rates even if inflation in early 2018 were to be revised up to, say, 5%!

Rather than lowering trend inflation to ensure a sustained and significant decline in interest rates, the government has effectively favoured higher near-term inflation so that interest rates can be brought down in the short term. It is ironic that governor Urjit Patel, a key architect of the path-breaking monetary framework reform to facilitate lower trend inflation, presided over its public crippling.

Rajeev Malik is a senior economist at CLSA, Singapore.These are his personal views.

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