Photo: Bloomberg
Photo: Bloomberg

Time for flexible monetary policy

Decisions on policy rate changes by the RBI should not be interpreted as dictations from the political authority

An unnecessary controversy has arisen with allegations of political pressure to lower policy rates. Those who interpret the stance of the Reserve Bank of India (RBI) as strict inflation targeting view a cut as bowing to such pressure. But what should matter are the arguments for and against a cut. For an economy as complex as India’s it is good to have these in the public domain and debated as widely as possible.

A central bank bases its actions on forecasts of future macroeconomic variables. Its current forecasts of inflation are much below those required for the glide path RBI has committed to. Low oil prices that are partly driving this are likely to persist, since technology has vitiated the power of Organization of Petroleum Exporting Countries (Opec) to fix prices. To regard a rise in oil prices as permanent and a fall as temporary is cognitive dissonance.

The other major component of inflation, food prices, is also moderating because of global softening in commodities, a low rise in minimum support prices, and some offloading of food stocks. The glide path is aimed at reducing inflationary expectations but food inflation has the largest impact on household inflationary expectations. As it has slowed, so has the rate of rural wage increase. The sharp wage rise was a reaction to unusually high food inflation, but these conditions have changed. Government expenditure pumped into rural areas also affected wages, and this has slowed since 2012 as foreign capital outflows forced a recommitment to fiscal prudence. If high food inflation raises core inflation, a fall must lower it.

Since we have 10 million young people entering the labour force every year, there is no constraint to expanding supply if the factors that raise costs moderate. Lower interest rates create more demand for industry which has excess capacity, while government spending creates more demand for food. Measures have been taken to meet fiscal deficit targets, and there is some restructuring of expenditure towards investment. With better fiscal policy, monetary policy can afford to soften.

The best coordination is not necessarily both tightening together. Rather each should target the area where it is most effective. At present, monetary relaxation can raise demand for a stagnant industry while changing the composition of government expenditure relaxes supply bottlenecks and refrains from creating excess demand in constrained sectors. There is space for industrial output to expand even in the short-run, while investment will slowly raise further capacity as demand rises.

A motivation for the gradual approach to the target implying flexible inflation targeting was to minimise the output sacrifice. The economy is currently over-performing on inflation reduction—4% is not yet an inflation target. Consistency with the data and the RBI’s modelling exercises both warrant cutting. Since output is below potential, and cost push is moderating, real positive repo rates are not required to achieve inflation in the range of 4% to 6%. Flexibility is essential in the Indian context.

Keeping the output gap negative since 2011 has reduced both growth and potential output—so why prolong the sacrifice longer than strictly necessary? Since the economy is very sensitive to extra high or low rates, taking no action as trend inflation falls will raise real rates and choke demand. The stance should be neutral not tight. Waiting to be absolutely certain before taking action has in the past led to over-and under-shooting aggravated by the lagged effects of policy rates. The RBI cannot afford to be behind the curve.

A cut, however, must not be steep, in order to maintain the focus on anchoring inflation expectations and the watch on food inflation. There is no need to over-react like after the fall of Lehman and collapse of oil prices when deep cuts resulted in over-stimulating the economy. But over-reaction in the other direction also has to be avoided. In the summer of 2008, October 2011, and June 2013, raising the repo rate despite peak rates and a slowing industry, put paid to industrial growth.

Since global demand is very weak, domestic demand needs to be stimulated all the more to compensate. Low credit growth and rising inventory of unsold houses point to weak demand. Industry may be postponing projects, and banks not cutting loan rates waiting for a signal from the RBI. They tend not to cut until they can see the path, to avoid locking in inappropriate interest rates. Despite the new government’s efforts, improvement in growth is marginal. In order to Make for India domestic demand must be allowed to rise.

There are other arguments for higher rates. First, industry is not in a position to invest because of stressed assets. But reviving demand will help get cash flowing, making some assets viable again. Second, Indian interest rates must rise with US to keep debt inflows here. But the 3 percentage basis point rise after the 2013 taper tantrum did not succeed in retaining these inflows. It is better to support growth. Third, the fall in oil prices is itself a demand stimulus. But not too much of this has been passed on as taxes rose. Analysts invested in a strict inflation targeting story did not expect cuts for many months, so the early December monetary policy did give a useful signal preparing markets for earlier cuts. Markets normally take the cue from the RBI, but the softening yield curve suggests they are ahead this time, and have a more sanguine expectation of inflation than the RBI seems to have. The December inflation figures, when base effects will wear off, should help it make up its mind.

Ashima Goyal is a professor at the Indira Gandhi Institute for Development Research, Mumbai.

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