The output gap and the pace at which it would close has been the main difference of opinion between the proponents of a cut in policy rates and those that desire a pause within the monetary policy committee (MPC).
Output gap is the difference between the actual output of an economy and the potential output it can generate at full capacity.
In the latest policy resolution statement, the Reserve Bank of India (RBI) said that MPC has kept the policy stance neutral “keeping in mind the output gap dynamics”. In other words, had the output gap shown signs of closing faster, as the central bank had anticipated in October, the stance may have been hawkish.
Indeed, the gross valued added (GVA) growth for the September quarter was a tad lower than RBI’s estimate and the central bank noted that the dent has been from higher oil prices and the softening of agricultural output.
This is soon expected to change. RBI states several factors that indicate an increase in growth: the increase in fundraising by companies from capital markets, the signs of resolution in distressed companies’ cases under the Insolvency and Bankruptcy Code, the expected attraction of foreign direct investment on the back of an improved ease of business rankings for the country and finally the recapitalisation of public sector lenders that will enable them to meet credit demand.
The central bank expects GVA growth to rise to 7% in the third quarter and 7.8% in the fourth quarter of the year. It has retained its outlook on GVA growth for the full year at 6.7%.
But the danger in output gap is that potential output and its growth rates for the Indian economy have been debatable. A 2016 working paper by RBI states that potential output growth may have fallen to 6.7% from about 7.2% in previous years. Government voices have vehemently argued that the potential growth rate is as high as 8%. International bodies such as the International Monetary Fund and even the World Bank have a slightly different number.
If we go by the RBI working paper’s assessment, then the output gap is poised to close very soon after which demand pressures would be enough to warrant tightening of the monetary policy. It would become easier for RBI to adopt a hawkish tone if inflation moves up as it expects it to, and the central government breaches its budgeted fiscal deficit target. The chances of both are getting higher by the day.
The chances of inflation moving up are stronger and the central bank expects retail inflation would quicken to 4.3-4.7% in the second half of fiscal year 2018. Revenue collection trends do not bode well for the government’s fiscal position.
How RBI will judge the output gap would perhaps become clearer after the Union budget in February. For now, the central bank is merely minding the gap.