The MPC: lost in translation
With the annual media tamasha over the Union budget behind us, it is time to replace the finance minister’s hat with that of the recently minted monetary policy committee (MPC). Will it announce a repo rate cut? Or will it stick to December’s ultra-safe script when it unexpectedly stayed on hold? At that review, the MPC fretted about the upside risk to inflation and flagged too much uncertainty following the unexpected and poorly implemented currency transfusion to justify staying on hold.
Frankly, I’m not sure what the MPC is waiting for before cutting the repo rate again. Inflation is highly likely to undershoot its March forecast of 5%, and another cut in the Reserve Bank of India’s (RBI’s) GDP (gross domestic product) growth forecast is already overdue. Recall that its GVA (gross value added) growth forecast for 2016-17 was lowered by 0.5 percentage point to 7.1% in December though it didn’t include adequate adverse hit from the disruptive currency swap.
More perplexing in the December policy statement was the MPC’s guidance of “evenly balanced risks” around its downwardly revised GVA forecast. How could the risks to its growth forecast be evenly balanced when, in the MPC’s own words, the outlook had turned uncertain and its revised forecast did not include a fuller impact of the hit from the currency swap? Other than government officials and politicians of the ruling party, the MPC members must be the only ones to think that there would be no negative impact on its revised forecast.
Even the government has finally bitten the bullet, with the Economic Survey (ES) cutting the real GDP growth forecast for 2016-17 to 6.5-6.75% from the original forecast of 7-7.5% in the prior ES. RBI’s revised forecast will be at around that range. The MPC should pay adequate attention to the warning in the ES that recorded GDP growth in the second half of 2016-17 will understate the overall impact of the currency swap because the most affected parts of the economy—informal and cash-based—are either not captured in the GDP data or, if included, are based on formal sector indicators.
The ES forecasts GDP growth of 6.75-7.5% (midpoint: 7.1%) for 2017-18. This is lower than the GVA growth forecast of 7.9% in the RBI’s biannual monetary policy report (MPR) in October. A cut of 0.5-0.7 percentage point in that forecast is highly likely. RBI could delay the revision until the next MPR in April and merely signal downside risk to its growth forecast.
What ultimately matters in an inflation targeting framework is the inflation outlook, though India has legally formalized a flexible version in which growth also plays an explicit role. Strangely, the inflation outlook in the last two policy statements—the only two so far by the MPC—raises several questions, including about the MPC’s consistency, guidance and communication.
Forgive yourself if after reading the October and December policy statements, you concluded that they were by either two different MPCs analysing the same economy, or the same MPC analysing two different economies. The October policy meeting was the first for Urjit Patel as governor and the MPC. A rate cut was announced and the tone of the guidance was quite dovish. Fast-forward two months to the December policy and the tone becomes unexpectedly hawkish—perhaps more than needed—to justify staying on hold. Since then, retail inflation has eased further in December, to a nearly three-year low of 3.4%. It will pick up in the current quarter but will still be below the RBI’s forecast for March.
There is more. While maintaining its near-term inflation forecast of 5%, the October statement highlighted that risks were tilted to the upside albeit lower than in the June and August policies. The December statement played this card again but added that the upside risk was lower than in the October review. This begs a simple question: Just how high was the original upside risk to inflation that it has been easing for several months and is still worth mentioning even though it didn’t have an impact on the inflation forecast?
Finally, the RBI cut the repo rate in October despite revising up the inflation forecast for early 2018 from 4.2% to 4.5%. The goal of achieving the medium-term target of 4% +/- 2% remains ambitious, and attaining it warrants heavy lifting by the government. The softer interpretation of the inflation mandate in the post-Raghuram Rajan regime offers scope to ease policy even if the medium-term inflation target, which has to be achieved over five years, isn’t within reach in the short term.
There is more to India’s inflation dynamics than just crude prices, whose impact will be more adverse. Domestic demand and corporate pricing power remain weak, and core inflation remains sticky downwards (neither is new). Unfortunately, no one has a good handle on the lasting impact on aggregate supply and demand channels following the currency transfusion and their impact on India’s growth-inflation mix. However, that isn’t a convincing reason for the MPC to stay put.
The MPC will need to be data dependent but it has only a narrow window for one or two repo rate cuts before disruptions kick off from the goods and services tax’s (GST) implementation in July. India’s GST is designed to be neutral on inflation but smooth and balanced implementation has never been our strong point. Rising US interest rates will further shrink the scope for RBI’s easing. The MPC should look through the mechanical and temporary impact on housing inflation from the implementation of the Seventh Pay Commission.
Monetary policy statements are written to justify policy action (or inaction). India’s infant MPC is still finding its feet. It should do some introspection to ensure a consistent and effectively communicated tapestry of its evolving economic assessment, action and guidance.
Rajeev Malik is a senior economist at CLSA, Singapore. These are his personal views.
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