BackRBI monetary policy: A close run thing
With arguments for and against a cut seemingly so finely balanced, wider political economy considerations may ultimately hold sway
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As the clock ticks down to the Reserve Bank of India’s (RBI) fourth bimonthly policy review of the year on 29 September, the policy decision facing the apex bank—whether to deliver a fourth 25 basis points reduction in its key policy this year or whether to remain on hold—is finely balanced.
A basis point is one-hundredth of a percentage point.
There are robust arguments for another rate cut. First, abstracting from the ongoing confusion over the revised national accounts, concerns over the pace of economic growth continue to linger, exemplified by unusually sluggish credit growth of just 9% over the last year.
Second, the near-term inflation conjuncture remains benign, providing a clear window for further policy ease. Wholesale prices are deflating at a pace not seen since 1976, while the more important Consumer Price Index (CPI) that RBI now targets shows retail inflation up just 3.7% in the year to August.
Low current inflation is, however, not unexpected. RBI governor Raghuram Rajan, for example, noted that CPI-based inflation was likely to be around 4% in August at the last policy review two months ago. But critically, inflation remains comfortably on course to undershoot RBI’s interim 6% target for January 2016. Of course, much of inflation’s current quiescence is thanks to the collapse in international oil prices over the last year and, despite this year’s increasingly deficient monsoon, historically low rates of food inflation that, in turn, largely reflect muted international prices. Signs that “core", ex-food and energy, retail prices might be accelerating, which were cited as a cause for concern at the last policy review, have also importantly petered out in the last two CPI reports.
Third, the US Federal Reserve’s recent decision to delay “lift off" at its September meeting helpfully reduces the pressure on the Indian rupee, further increasing RBI’s short-run room for manoeuvre. The rupee has nonetheless fallen by around 4% against the greenback since the last policy review as increased uncertainty over China’s economic prospects has seen financial market volatility spike.
On the other side of the ledger, however, several counter-arguments also carry weight. First, higher frequency indicators suggest that economic growth is, in fact, now accelerating. Steel and cement production, rail freight and commercial vehicle production have all shown a marked pick-up over the summer. And an upswing in capital goods output is also increasingly evident, suggesting that the capital expenditure (capex) cycle is finally turning.
The key counter-argument against a further rate cut, however, is simply that low inflation today simply cannot be taken for granted. The restraining impact of falling international oil and food prices must eventually fade, with base effects from the former set to become progressively more challenging from October onwards. This year’s increasingly deficient monsoon, now around 14% below long-run norms compared with just 4% deficient when RBI last met, is also showing signs of rekindling food inflation. The August CPI report showed the prices of pulses and onions in particular spiking higher.
Worryingly, as RBI has previously emphasized, prices of protein-rich food sources, in particular, tend to be both sticky and have an out-sized impact on inflation expectations. RBI’s latest survey on household inflation expectations showed these picking back up into double-digit territory, underscoring that RBI’s primary focus, the restoration of inflation control, remains very much a work in progress.
Lastly, the so-called transmission of the 75 basis points of rate cuts has remained depressingly limited. The biggest banks have only lowered their base rates by 27.5 basis points since the start of the year, passing on only around one-third of RBI’s intended easing. Governor Rajan has repeatedly expressed frustration at the situation, and the lack of pass-through to effective lending rates was cited as a key reason to delay further easing at the third policy review. Two months on, little appears to have changed; banks remain risk-averse and loath to reduce lending rates. Further easing by RBI is therefore unlikely to have any meaningful impact on the real economy, but could unhelpfully impede the required downward progress in inflation expectations.
With the arguments for and against a further 25 basis points easing seemingly so finely balanced, wider political economy considerations may ultimately hold sway. The ebb and flow of relations between RBI and the finance ministry can be thought as a “third dimension" to monetary policy after the more familiar domestic macroeconomic and external balance considerations.
Finance minister Arun Jaitley has been publicly calling for lower rates even as RBI governor Rajan has admonished that rate cuts are not “goodies" to be doled out in response to repeated “public pleading". But, with the delicate negotiations over the composition of the RBI’s new rate-setting monetary policy committee reportedly nearing conclusion and Rajan reportedly set to receive both his desired committee structure and retention of deciding vote, RBI may understandably choose to respond with a rate cut “goodie". If so, expect the accompanying policy statement to be hawkish, confirming both the decision was a close call and that scope for any further policy ease is now likely extinguished.
Richard Iley is chief Asia economist at BNP Paribas SA.
This is the last in a three-part series ahead of the Reserve Bank of India’s bimonthly monetary policy review on 29 September.
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