RBI’s policy review: A subtle bias for accommodation
The premise to the second bimonthly monetary policy review had turned interesting as the recent decline in inflation was in sharp contrast to the upward revision in inflation estimates by the Reserve Bank of India (RBI) in April. With global inflation risks also receding somewhat in the interim, and prospects for India’s south-west monsoon improving on the margin, the markets were expecting a softer guidance from the central bank after a hawkish assessment in April.
While the RBI’s monetary policy committee (MPC) maintained status quo on repo rate (in line with expectations), it provided a calibrated outlook on the economy along with a nuanced guidance. There are three key takeaways from the policy outcome:
—There has been a substantial downward revision in inflation estimates for the current financial year. RBI now expects consumer price index (CPI) inflation to range within 2.0-3.5% in H1 FY18 vis-à-vis its previous estimate of 4.5% provided in April. While inflation is expected to trend higher in the second half to 3.5-4.5%, the estimate is now lower compared to the 5.0% level provided earlier.
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—Along with the policy review, the RBI reduced statutory liquidity ratio by 50 basis points to 20.0% of net demand and time liabilities of banks and also announced lowering of risk weights for housing loans.
—Since the formation of the MPC, this is the first time that the monetary policy decision has not been unanimous, with one of the six members likely to have voted for a rate cut.
All of them put together signal a subtle bias for monetary accommodation. In my opinion, this clearly paves the way for a strategic 25 basis points rate cut in the next policy review in August. So, why did the MPC then refrain from an outright shift in its neutral policy stance and opt for a rate cut instead?
Playing cards close to the chest
RBI appears to be besieged by the degrees of uncertainty surrounding its short-term inflation forecasts (in a depiction of asymmetrical risks, the average H1 inflation estimate is revised lower by 175 basis points or bps while average H2 estimate is lower by 100 bps). The recent downward swing in food inflation has surprised not only the central bank, but also the professional forecasters. Clarity on its sustainability would emerge with monsoon’s evolving typography and the government’s policy decision on resetting of kharif minimum support prices in the coming months. Meanwhile, risks of fiscal slippage for states have risen with announcements of large farm loan waivers—this can have a lagged inflationary impact. While goods and services tax is not likely to have a meaningful impact on inflation in FY18, the manner of disbursement of allowances under the seventh central pay commission (CPC) report entails upside risks. The uncertainty gets compounded by timing, as some of these risks (if they were to play out) could potentially push headline CPI inflation above 5% levels towards the end of FY18, compared to its medium-term target of 4%, thereby putting policy credibility at risk. Hence, it’s natural for a nouveau inflation-targeting central bank to err on the side of caution and prefer being reactive rather than proactive to downside surprises in inflation, especially at the end of the rate cutting cycle.
The next step from here
Recent inflation dynamics have clearly turned favourable for India with active policy support (efficient management of food economy amid steady progress on reforms) and good fortune (favourable monsoon and benign global conditions). With output gap likely to remain negative in the short term, recovery in pricing power could be subdued. The MPC could take this opportunity to streamline its assessment framework by:
—Unambiguously emphasizing that it is ready to ignore the technical impact of implementation of CPC allowances on inflation.
—Chiseling the policy target by migrating to average annual inflation vis-à-vis point target currently to avoid monthly vicissitudes of non-core items in inflation like food and fuel.
Both these steps could help RBI get a clearer picture by filtering out demand-side factors from statistical adjustments to inflation and increase its degree of freedom with respect to the objective of supporting economic growth.
Shubhada M Rao is group president and chief economist at Yes Bank Ltd.