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Business News/ Opinion / Online-views/  Monetary policy: A rate cut mirage
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Monetary policy: A rate cut mirage

If RBI is serious about CPI inflation reaching 6% by early 2016, further policy tightening, to the inevitable chagrin of the NDA administration, may yet be needed

No central bank, least of all RBI, operates in a political vacuum and the last policy statement is best interpreted as another salvo in the ongoing game of cat and mouse between RBI and North Block. Photo: MintPremium
No central bank, least of all RBI, operates in a political vacuum and the last policy statement is best interpreted as another salvo in the ongoing game of cat and mouse between RBI and North Block. Photo: Mint

The second bi-monthly monetary policy statement released by the Reserve Bank of India (RBI) in early May struck a surprisingly dovish note. Previous tacit references on the potential of the policy repo rate (or the rate at which the central banks lends to banks, thereby infusing liquidity into the system) to rise further from its current 8% were dropped. Despite the bank’s consumer price inflation forecast fan chart (one that shows a range for this in the future) still clearly showing price rise risks to its 8% inflation objective by early 2015 decisively skewed to the upside, the policy disingenuously described inflation as still broadly balanced.

Raising the prospect of stronger government action on food supply and faster fiscal consolidation, the statement further hinted that even rate cuts were possible if inflationary pressures faded faster than currently anticipated.

No central bank, least of all RBI, operates in a political vacuum and the last policy statement is best interpreted as another salvo in the ongoing game of cat and mouse between RBI and North Block (where India’s finance ministry is housed). The deliberate downplaying of latent upside inflation risks and emphasis on the scope for rate cuts provided the appropriate fiscal policy, must be viewed as an understandable, even laudable, attempt by RBI governor Raghuram Rajan to establish a co-operative equilibrium with the new National Democratic Alliance government.

Finance minister Arun Jaitley’s budget, delivered on 10 July, however, is likely to have left Rajan underwhelmed. While the budget paid welcome lip-service to continued fiscal consolidation, ambitiously aiming to stick to the previous administration’s deficit target of 4.1% of gross domestic product for 2014-15, there was a strong whiff of déjà vu about the budget’s underlying assumptions. In particular, the optimistic tax and spending assumptions were redolent of the previous United Progressive Alliance’s fiscal legerdemain. Details on subsidy control and a hard timetable for the introduction of the goods and sales tax in particular were depressingly absent. The clear risk, therefore, is that, while fiscal consolidation will slowly continue, it will remain low-quality with departmental capital spending budgets continuing to bear the brunt of redressing the inevitable slippage relative to target. In the final analysis, the budget provides little, if any, additional support for RBI’s anti-inflation campaign.

Inflation data published since RBI’s last policy statement has been better-than-expected but, like the budget, not a game changer for the apex bank’s interest-rate deliberations. Headline CPI (Consumer Price Index) inflation slipped back to 7.3% (year-on-year) thanks to a mix of lower food inflation (especially vegetables) and a welcome easing of underlying ex-food (other than food) and energy inflation pressures. While the latter suggests sluggish economic growth of recent years is finally starting to pull down sticky core pressures despite still elevated household inflationary expectations, the former is unlikely to last. While the latest news on the monsoon showed some progress on rainfall catching up with its 50-year average, it is still 27% deficient, leaving the country on course for the worst drought since 2009.

With the ministry of consumer affairs reporting many vegetable prices already jumping 25-50%, food inflation, which sagged to a 28-month low of 8% in June, is likely to quickly snap back to double-digit territory in the second half of 2014-15. While this is unlikely to be sufficient to blow CPI inflation decisively off its desired target of 8% by early 2015, another high-profile bout of food inflation will almost certainly impede the re-anchoring of household inflationary expectations and, by implication, further disinflation in core inflation. The desired glide path of CPI inflation down to 6% by early 2016 remains a forlorn hope despite recent better-than-expected data. Those traditional bugbears for RBI—an absence of decisive fiscal support and a deficit monsoon fuelling rapid food inflation—should ensure hopes for easier monetary policy remain chimerical.

Indeed, if RBI is serious about CPI inflation reaching 6% by early 2016, further policy tightening, to the inevitable chagrin of the NDA administration, may yet be needed.

The author is chief Asia economist, BNP Paribas

This is the first in a series of three articles ahead of RBI’s bi-monthly monetary policy review on 5 August.

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Published: 30 Jul 2014, 12:01 AM IST
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