Photo: Hindustan Times
Photo: Hindustan Times

‘Mission 4%’ for lower trend inflation

Launch 'Mission 4%' to achieve a new low and stable normal for trend inflation

The forthcoming monetary policy meeting on 4 October will be the first for Urjit Patel as Reserve Bank of India (RBI) governor. It will also be the first for the newly constituted six-member monetary policy committee (MPC), unless there is a delay in notifying some of its operational procedures. Finally, the RBI will also publish its biannual monetary policy report, which will contain its detailed assessment of inflation over the next six to 18 months.

In light of a new governor at the helm who will have to manage a reformed structure of how policy interest rates are decided, it is useful to take stock of where we are on inflation, where we want to be and how we can get there in the least disruptive manner. India’s political and economic aspirations for sustained high-level growth will remain unfulfilled unless the Narendra Modi government sorts out the inflation dynamics.

India’s retail inflation had risen to a two-year high of 6.1% in July. In its monetary policy review in August, the RBI highlighted the upside risks to inflation, but maintained that policy remains accommodative. The increase in inflation was widely expected to be temporary.

And it was. Thanks to lower food prices, the better-than-expected consumer price index (CPI) inflation of 5% year-on-year in August increases the probability of a repo rate cut at the October policy meeting. Core inflation, however, remains stubbornly elevated despite weak corporate pricing power. Headline inflation will likely move lower before moving up to be at, or slightly below, the RBI’s inflation forecast of 5% for early 2017. That trajectory justifies limited policy easing after a pause following the last rate cut in April.

Some could question the unfavourable optics of a repo rate cut being announced at the very first policy meeting of the governor and the new MPC. However, giving legitimacy to that angle would be unfortunate, in my view. The RBI’s flexible inflation targeting framework offers convincing reasons for limited easing. In fact, if the central bank is true to its own transparent monetary framework, it shouldn’t be bothered by the conspiracy angles.

Frankly, the rate cut could also be postponed until the subsequent meeting if confirmation from another “welcome" inflation print is needed. That, of course, would be an understandable insurance move by a cautious central bank still working to boost its credibility.

Away from the limited room for easing that has emerged is the following crucial question: What is the probability of achieving the RBI’s inflation forecast of 4% by early 2018? The short and quick answer for now is “very low".

It should be pointed out—and the MPC will need to clarify—that the inflation target of 4% over the next five years as agreed between the government and the RBI is not the average outcome over that period. In the current operational framework, the RBI will need to bring inflation towards the middle of the 2-6% band (i.e. 4%) and then ensure that it hovers around that level.

The lower (2%) and upper (6%) bounds of the inflation targeting framework make for a very wide range. There is misinterpretation in some quarters that the “flexible" nature of inflation targeting adopted by India offers scope for the central bank to live with higher inflation—but below the upper bound—in the short term in order to boost growth. The wide inflation band is meant to offer more time for an adverse impact of a shock to be reversed gradually, rather than resorting to a sledgehammer approach.

Anyone in doubt about how much flexibility there is should digest Patel’s comment following the August policy meeting. He had said about the inflation targeting framework: “It is a range and therefore a tad bit of flexibility is endowed…." That characterization doesn’t suggest too much flexibility to me.

How do we achieve the inflation target of 4%? It is ambitious but not impossible, though the onus of the heavy lifting is on the government. I wish the government would approach that target on a war footing. The Modi government has announced a slew of initiatives and missions—Make in India, Skill India, Clean India, etc., to transform the economy. A formal initiative, say, “Mission 4%", with credible details, including supply-side measures, to deliver low and stable inflation around the 4% forecast would go a long way in increasing the probability of achieving that goal.

Volatility in food inflation is a key driver of the swings in headline inflation (see chart). Food inflation has averaged 5.9% between June 2014 and August 2016, but actual monthly outcome shows wide variation—often within a few months—compared with that average. The fact that these food shocks are generally random works against reliable inflation forecasts and the anchoring of household inflation expectations.

Monetary policy cannot fix food inflation but it has to be on guard against its second-round impact on core inflation and on inflation expectations. This is especially relevant in a supply-constrained economy such as India, where near-term growth will be powered by improving private consumption. It also has to ensure that the aggregate demand and supply are in balance. Indeed, enhancing the economy’s supply side will yield both lower inflation and higher growth—a win-win outcome.

The government should announce a Mission 4% which contains specific measures to lower food inflation volatility and to address the excess demand imbalances in some service sectors that keep core inflation rigidly elevated. Investors will lap up credible measures and be increasingly confident of a new low and stable inflation normal at 4%. That in turn will open up room for a significant downshift in interest rates.

Like the preference for lower pollution, everyone understandably desires lower interest rates. However, policy adventurism aside, a significant structural decline in interest rates in a supply-constrained open economy can only occur when trend inflation has a lower normal. I hope the Modi government is paying attention.

Rajeev Malik is a senior economist at CLSA, Singapore. These are his personal views.

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