Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

Over to you, MPC

The October policy would mark the first policy decision under the aegis of the newly formed Monetary Policy Committee

Since January 2015, the Reserve Bank of India (RBI) has been responding to falling inflation by easing monetary policy. In addition, the stance on liquidity underwent a significant change from ‘tight’ to ‘neutral’ in the last six months. More importantly, the central bank continues to signal an accommodative bias in its future guidance.

Despite this, there has been a policy status quo since April 2016 as a prolonged summer that resulted in an acceleration of food inflation and a moderate hardening of global commodity prices provided an upside risk to RBI’s projected inflation target of 5% for March 2017.

However, both these risks have now failed to crystallize and room for incremental monetary easing is opening up.

Global commodity prices, especially crude oil at around $45, have stabilized, with risks evenly balanced in the near-to-medium term. More importantly, the monsoon has been normal so far (with cumulative south-west rainfall at 97% of the long period average) after two consecutive deficient years.

Moreover, healthy reservoir levels suggest that sowing conditions for the upcoming rabi season are also likely to be conducive.

The government’s first advance estimate for 2016-17 kharif production is extremely encouraging. Total foodgrain production is projected to touch a record 135.03 million tonnes, exceeding the full-year target by 2.28 million tonnes. Led by pulses, oilseeds and coarse cereals, growth in foodgrain production is expected to touch 8.9% in the year 2016-17. In the last two years, it shrank by an average 1.9%.

In fact, the preliminary impact of improvement in acreage has already started to show. In August, the food index in consumer price index (CPI) contracted by 0.4% against the average increase of 1.5% observed during the same month in the previous five years. More importantly, information on high frequency mandi prices indicates that the sequential deflation in the overall food index could gather further pace in September.

This is likely to take the headline CPI inflation to 4.5-4.6% in September 2016 and further towards 4% by December 2016. If rabi sowing also turns out to be as good as kharif, food inflation could remain subdued, thereby keeping headline CPI inflation around 4.5% by March 2017, 50 basis points (bps) lower than the target. One basis point is one-hundredth of a percentage point. This, in my opinion, will open up space for incremental monetary easing. RBI can be expected to cut repo rate by 25 bps in its upcoming policy review on 4 October so as to maximize the impact of supportive domestic and global factors.

These would be factors such as an expected pickup in domestic demand due to the fortunate alignment of enablers like the Seventh Central Pay Commission (CPC) payouts, supportive monsoon and upcoming festive season in India.

A rate cut at this stage would help in boosting sentiment while contributing towards an improvement in capacity utilization in the economy. Second, US Federal Reserve opted to stay put in September 2016 while signalling the possibility of a 25 bps rate hike in December. Hence, this provides a timely window for RBI to go in for incremental monetary easing in order to avoid any one shot knee-jerk impact on interest rate spreads and currency movement.

MPC to be instrumental in anchoring long-term policy trajectory

The October policy would mark the first policy decision under the aegis of the newly formed Monetary Policy Committee (MPC). The migration to a committee-based monetary policymaking, akin to countries such as the US and the UK, is expected to provide two key advantages.

One, with the external members in MPC getting a four-year term, continuity of monetary policy would benefit. Two, monetary policy would henceforth be a decision based on the collective wisdom of all the MPC members.

However, for the new dispensation in monetary policymaking to be successful in shaping expectations, it is important to publish the minutes of the meeting, along with the economic assessment done by each of the three external members.

While there is visibility on the near-term trajectory of monetary policy, the medium-term trajectory remains open to interpretations.

In my opinion, the MPC needs to urgently set its thought process rolling with respect to the following factors.

One, how to treat the impact on headline inflation after the implementation of allowances under the 7th CPC towards the end of FY17.

Two, what kind of disinflationary impact would structural reforms like the bankruptcy code and goods and services tax imply from a longer term perspective?

Three, can flexibility under the inflation targeting framework be employed to support growth conditions, if overall reforms continue to proceed in the right direction?

Four, would the MPC be also consulted for other critical policy variables such as liquidity, exchange rate etc. which can have a bearing on overall monetary policy stance?

While markets are currently pricing in an immediate rate cut from RBI, the focus should be on the evolution of the epochal MPC. This could emerge as a successful game changer in the history of India’s central banking.

Shubhada Rao is chief economist at Yes Bank. This is the second in a series of expert columns in the run-up to RBI’s bi-monthly policy meeting on 4 October.

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