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Business News/ Opinion / Online-views/  RBI’s shift in policy stance is puzzling
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RBI’s shift in policy stance is puzzling

With demonetisation's impact on economic growth still evolving and nothing materially changing from December, RBI maintaining status quo on interest rates was expected

The RBI’s assessment of the global situation is centered on the policies of the US, impact of Brexit and oil prices. Photo: Aniruddha Chowdhury/MintPremium
The RBI’s assessment of the global situation is centered on the policies of the US, impact of Brexit and oil prices. Photo: Aniruddha Chowdhury/Mint

“When it comes to growth rates do not trust your intuition- because you don’t have any!" –Rolf Dobelli.

Perhaps this statement best sums up why the Reserve Bank of India (RBI) decided to maintain a status quo, contrary to market expectations. With the impact of demonetisation on growth still evolving and nothing materially changing from 2016 December, a status quo was expected. However, what was puzzling was the abrupt shift in policy stance from accommodative to neutral.

The RBI assessment of the global situation is centered on three themes—the internal and external policies of the US administration, impact of Brexit and oil prices. Beyond Brexit, a series of elections in Europe notably in the Netherlands, France and Germany are pending and might realign the political space. This will alter the global economic narrative. This assessment is largely correct but it possibly masks the considerable risk that India faces. The outlook for global growth rightly remains uncertain and unpredictable. The policy signals like abrogation of Trans-Pacific Partnership (TPP) agreement by the US, H-1B visa and rising protectionism in both the European Union (EU) and US will compound the existing negative outlook for India. But on the positive side, rising protectionism can enable India to decouple from dollar. Again this backdrop, the decision to not cut rates is appropriate as demonetisation has led to considerable transmission of previous rate cuts and full impact of process of remonetisation is still unclear.

ALSO READ: RBI signals end of rate cut cycle

However, there are a few imponderables. Intriguingly, for the third time in a row, the rate decision was unanimous. Even though it is too early, such unanimity reminds us of the Federal Open Market Committee (FOMC) proceedings. On paper, FOMC was always a pure committee that reached decisions by majority vote. For that matter, Alan Greenspan chaired FOMC for over 18 years and was never on the losing side of a vote. Nor did he ever eke out a close victory.

Second, there are significant apprehensions regarding the stickiness of core inflation. The irony regarding CPI numbers is that core CPI average (January 2015-December 2016) is currently running at 4.6%, significantly lower than 6.6% average (January 2014-December 2014). This only indicates the pitfalls of targeting CPI inflation with a larger food component. In our view, there is a minimal probability of core CPI dropping below 4.5% on a sustained level and hence the only way CPI could be lower is through food prices declining. Thus the onus is again on the government for ensuring effective supply-side management.

RBI had conducted an interesting study for the period 2002-06 which concluded that more empowered MPCs seem to deliver better inflation results but with no improvement in growth outcomes.

Interestingly, the result for the period 2009-15 changes as inflation is surprisingly increasing with more MPC empowerment but with no improvement in growth outcomes. Thus again the pitfalls in inflation targeting!

ALSO READ: RBI cites inflation concerns, signals end to rate cut cycle

The monetary policy also seems to possibly differ in its assessment regarding the net borrowing target at Rs3.48 trillion by the government. For example, for timely transmission of interest rates to bank rates, the policy has advocated the reduction of gap between the interest on small savings and bond yields. This comes even as the government is budgeting a surge in small saving collections in next fiscal to Rs1 trillion. State governments (excluding four states) have been recently allowed to fund most of their requirements from market borrowings rather than small savings. Thus, the estimate could be optimistic on this account, unless the government deliberately keeps the interest rate offered on such schemes at more attractive levels relative to market interest rates.

The positive spin from a possible shortfall in small saving collections is a jump in short-term borrowings leading to capital inflows and hence rupee appreciation. Empirical evidence suggests that countries embarking on inflation targeting typically face an appreciating exchange rate that feeds into lower inflation at least through imported channels.

Finally, let me play a devil’s advocate here. There has been a lot of talk regarding the independence of the central bank in recent times. We believe, at an operational level what really matters was the continued fiscal dominance, including large temporary mismatches between receipts and expenditures of government warranting large involuntary financing of credit needs of the government by the RBI.

This is now a thing of the past with the Fiscal Responsibility and Budget Management (FRBM) Act. Also, with the setting up of the inflation targeting framework, rate setting is now divorced from political considerations. The only thing that could be more frequently used in exerting RBI independence could be perhaps more of communication.

Soumya Kanti Ghosh is group chief economic adviser of State Bank of India.

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Published: 09 Feb 2017, 02:26 AM IST
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