Monetary Policy Committee: More questions than answers
Last week’s statement of India’s five-meeting-old monetary policy committee (MPC) raises more questions than answers. That, however, hasn’t prevented investors—long hungry for a repo rate cut—from factoring easing as early as the next meeting in August. The May inflation outcome will increase the decibel level about that expectation.
The reality, however, is more nuanced, and the probability of a rate cut is low and one that soon could be even lower. Investors are underestimating the risk of the MPC not achieving the ambitious inflation target of 4% on a sustained basis despite near-term inflation being temporarily well below that level.
In its first nine months, the MPC has gone from cutting rates and sounding dovish (October) to sounding hawkish and unexpectedly shifting its stance to neutral from accommodative (February), to slashing its inflation forecast (last week). A substantial 1.4 percentage-point miss on its inflation forecast for 4Q FY17 wasn’t enough to justify easing. Last week’s revision of the inflation forecast to 2.0-3.5% (from 4.5%) for 1H FY18 and to 3.5-4.5% (from 5%) for 2H FY18 didn’t even result in an unambiguous signal of imminent easing.
An inflation targeter not cutting rates despite a massive inflation forecast miss or a significant downward revision to the inflation forecast—as has been the case in India—carries a strong signal: the MPC isn’t itching to ease. A common theme in both instances was the MPC adopting the infamous “considerable uncertainty” and “waiting for more clarity” to justify inaction. That is odd since the MPC was convinced enough to revise its inflation forecast. If every policymaker waits for her forecast to be realized before acting, we can say goodbye to forward-looking policymaking.
One wonders whether the inflation forecasts matter to this MPC. It cut rates in October despite the inflation forecast being revised higher. Last week, it slashed its inflation forecast but did nothing on the repo rate. It needs to better communicate its inflation-repo rate response function.
By August, the MPC will have inflation details for May and June. Are the data for two more months sufficient to clear the uncertainty about the sustainability of the drivers and to convince it that the downshift is structural, hence sustainable? Probably not, but then this MPC can wing it any which way it feels like.
To be sure, food inflation has been softening after peaking in July. However, that softening momentum didn’t prevent the MPC from shifting its stance to neutral from accommodative in February. Given that food has a high weight of 39.1% (45.9% including beverages) in the consumer price index (CPI) basket, the key question is the sustainability of the deceleration. This is especially relevant in light of a general election in less than two years and the current farm distress, which is making loan waivers politically convenient.
The softening momentum in food inflation is probably an outcome of a combination of favourable factors and the lingering impact of demonetisation, as the MPC has indicated, instead of a paradigm shift that confirms food inflation will remain benign for good. Food inflation has come off from the prior elevated levels, with the typical swing from the hit due to a poor monsoon to the boost in production from a normal monsoon. The price action in pulses is the best reflection of this pattern (see chart). It will normalize after a few months. The government undoubtedly deserves credit for effective management of some food prices. However, there is still no institutional framework that ensures sustained confidence of low and stable food inflation.
One area where the MPC deserves sympathy is that the typical increases in food prices in recent months (especially April) haven’t played out. This has been a key source of the inflation forecast miss by the MPC and other forecasters. There is a reason for this: forecasting the food price index in India’s case is a mug’s game. That is the main factor why the margin of error in forecasting inflation in Asian countries is perhaps the greatest in India.
If indeed there is a favourable structural supply-side response—measured beyond just a few months and beyond the comparison with prices during the high inflation years—that is great news. However, such a conclusion is premature and I doubt the MPC can decide by August. Also, given the current stress in agriculture, government response to reverse the collapse in the prices of some food items is highly likely. The MPC should also be mindful about potential reflationary policies for agriculture and rural areas; these are going to add momentum to the already visible acceleration in the inflation-adjusted rural wage growth.
The bottom line is that the MPC has to be confident about delivering inflation close to the 4% target on a sustained basis. That means over a long period, not just a few months. Admittedly, the downward adjustment is more pronounced than expected, but it cannot ease now unless it is sure of achieving the target on a lasting basis. It is better to stay put and ride out the exaggerated softening—not for the first time—rather than ease now and then have to raise rates soon.
A partial monetary easing for housing has already been announced. One more repo rate cut is unlikely to make a meaningful difference to growth, but the loss in the infant MPC’s credibility—vastly under-appreciated by most stakeholders—is a big risk. Government officials, who are in overdrive to push for lower rates, will be convincing if they back their views with a forecast.
India is nowhere close to ensuring CPI inflation of 4%, especially when the growth accelerates and pricing power returns. The MPC should appreciate that credibility is earned, never regimented. It is also not enhanced by succumbing to bullying.
Rajeev Malik is a senior economist at CLSA, Singapore. These are his personal views.
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