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Business News/ Opinion / Online-views/  RBI monetary policy: Read the tea leaves
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RBI monetary policy: Read the tea leaves

Given the real policy rate target and RBI's inflation expectations, there is space for only a quarter percentage point of more cuts

Photo: BloombergPremium
Photo: Bloomberg

The monetary policy meeting of the Reserve Bank of India on Tuesday was a non-event, exactly as it should have been. A key objective of targeting inflation is to introduce an element of transparency and predictability about monetary policymaking that allows economic actors to anticipate and plan. True, the timing of the two inter-meeting cuts may have been a surprise to some. But no one would grudge the actual actions. When inflation is 3 percentage points below a central bank’s stated target (like it was in January), demonstrable urgency is understandable. Space for some easing had clearly opened up.

However, with rates already being pared by half a percentage point, the bar for each successive cut was always likely to get higher. With February retail inflation surprising to the upside, weather shocks posing a risk to food prices in the coming weeks, and state governments not budgeting for any fiscal consolidation this year, which is likely to make consolidated fiscal policy slightly expansionary for the first time in many years, any expectation of a rate cut was always unrealistic.

The case for a cut in the cash reserve ratio (CRR), or the portion of deposits banks have to hold as reserve with the central bank, was even harder to rationalize. On the one hand, RBI has been intervening aggressively in the forward foreign exchange market to ensure it is able to prevent the rupee’s appreciation without injecting liquidity. Why would it then permanently do so by cutting CRR? The risk this year is not of liquidity remaining too tight. With the current account deficit so low, a US Federal Reserve liftoff pushed out and India receiving more than its share of capital inflows, the balance of payment (BoP) surplus will be so large and require so much intervention that RBI will do well to just keep liquidity in deficit mode. Faced with these expected pressures, why would the central bank consider cutting CRR now? So no real surprises on policy day.

The real message from the policy announcement is that the space for monetary easing in the coming months and years is limited. Markets will have to live with that reality. RBI governor Raghuram Rajan has repeatedly spoken about keeping real policy rates between 1.5% and 2%. This is critical to re-intermediating household savings into financial assets. When the investment cycle eventually picks up, it’s imperative that it is financed by domestic, and not foreign, savings. The latter would necessarily entail a larger current account deficit at a time when the Federal Reserve is in the midst of a hiking cycle, and global capital may be far more diffident towards emerging markets.

Given this real policy rate target and the fact that RBI expects inflation to firm up to 5.8% by the end of the fiscal year (consistent with our own forecast), there is space for only a quarter percentage point of more cuts, which we pencil in for June. For those who believe a real rate of 1.5-2% is too high, consider this: real policy rates averaged 2.6% between 2002 and 2007, when investment was growing in double digits.

More generally, under the monetary policy agreement, RBI’s next inflation target is 4% by March 2018. While there is undoubtedly a tolerance band of plus or minus 2 percentage points, RBI was emphatic in noting it would condition policy to stay close to the centre of the band. What this means is that, even in the best case scenario of 5% retail inflation next year at this time, inflation would be towards the upper end of the band, and space for easing won’t necessarily open up.

So markets and economic agents need to realize we are in the midst of a tectonic regime shift. That monetary policy does not have much more space to engineer a cyclical recovery. Other agents in the system need to take over. For starters, banks need to transmit prior rate cuts. Transmission is notoriously asymmetric in India with rate hikes quickly passed on but rate cuts aren’t. The fact that RBI will insist that base rates be driven by marginal, rather than average, costs is a welcome institutional development. Now, the government needs to do its part by liberalizing small savings schemes that are impeding transmission.

More fundamentally, however, any durable acceleration in growth needs to be structural, and driven by the supply curve shifting out. Kudos to the government for ploughing ahead with reforms in the coal and mining sector and not backing down on the controversial land acquisition ordinance. We need more of this. It’s only supply-side reforms—that boost potential growth—that can deliver both growth and economic stability. Otherwise, we will always be forced to choose between one or the other.

Sajjid Chinoy is chief India economist at JPMorgan Chase and Co.

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Published: 08 Apr 2015, 12:47 AM IST
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