The sustained case for an RBI rate cut
The constellation of recent economic data has led to the consensus view that the monetary policy committee (MPC) of the Reserve Bank of India (RBI) has no room to reduce policy interest rates this week. It is a compelling argument. Inflation has climbed rapidly after hitting a low in June, and is likely to overshoot the 4% mark by the end of the current fiscal. Core inflation is sticky. Global commodity prices—especially crude oil—have hardened. Economic activity picked up in the September quarter. Many other central banks are likely to tighten monetary policy in the months ahead if the worldwide economic recovery strengthens.
This newspaper continues to stick to its October call that there is a cautious case for a rate cut. In our view, the persistence of the output gap is currently a bigger worry than inflation going out of control. Actual output is at least one percentage point below potential, at a time when most other major economies are gaining momentum. Macro policy has to respond to the effects of two successive policy shocks—demonetisation and the transition to the goods and services tax (GST)—given the risk of hysteresis. The fiscal policy option has already been exhausted.
Does the output gap matter? The new monetary policy framework defines the loss function that a central bank has to minimize in terms of deviation from the inflation target on the one hand and deviation from potential growth on the other. There is reason to believe that the latter is more important than the former right now. This would be a good time for the MPC to signal that its commitment is to flexible inflation targeting rather than pure inflation targeting.
The other issue that needs attention is the recent tightening of financial conditions. The rupee has appreciated. Bond yields have gone up. One easy measure of this is the growing gap between the policy interest rate and the yield on the benchmark 10-year bond. In other words, the yield curve has become steeper.
The Reserve Bank of India (RBI) is now facing the classic dilemma for any central bank in a country with a relatively open capital account. It has had to buy dollars to prevent sharp rupee appreciation. The dollar buying means the Indian central bank has to release rupees in a money market that is already in surplus (though the banking sector surplus has come down since the peak seen immediately after demonetisation). The RBI has conducted open market operations to mop up this excess money market liquidity, but its bond sales have pushed up interest rates. It was eventually forced to cancel a bond sale at the end of November, when benchmark bond yields crossed 7%. Meanwhile, the State Bank of India has already raised its interest rate for bulk deposits.
The liquidity dilemma is not the direct concern of the MPC, but it continues to be an important challenge for monetary policymakers. The complicated choice between letting the rupee appreciate, keeping liquidity as close to neutral as possible, and preventing rising bond yields cannot be based on simple binary decisions. In case the MPC decides to keep policy interest rates at the current levels—and that seems likely despite our preference for a rate cut—the monetary policy will have to depend more on liquidity operations to deal with the recent tightening of financial conditions.
Much also depends on government policies in the months ahead. Indian governments have in recent decades tended to loosen the purse strings before every national election. The last full budget of the Narendra Modi government that is due in a few weeks needs to be watched carefully for its inflationary potential.
The government also managed the food economy deftly in its first three years, but the disquiet in the countryside because of food deflation is bound to be a concern for any rational political party.
The MPC will have to second-guess what the government will do in the months ahead in terms of higher rural spending as well as higher support prices, but it is likely that these decisions will be taken only in the second half of the year, which gives a window of opportunity to the committee to cut rates this week.
Should the monetary policy committee cut interest rates? Tell us at email@example.com
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