RBI monetary policy delivers no surprises
The Reserve Bank of India (RBI)’s decision to cut the repo rate by 25 basis points was as per the market consensus and there were no major surprises. However, the policy did spring a gentle surprise by devoting considerable attention to growth pangs and projecting an inflation trajectory that is now a lot closer to ground realities.
A rate cut was perhaps a foregone conclusion given that the global and domestic economy are both caught in a vicious cycle of low growth (though recuperating from low levels) and low inflation. The fixed-income markets in US and even India are now caught in the “Alan Greenspan Conundrum” with a very narrow differential between short term and long term spreads globally and in India.
Thus globally, while the nominal gross domestic product of US may have picked up after a dip in the first quarter, the underlying economic conditions in the US are not so encouraging. The most disturbing signs came from the latest downgrade of the state of Illinois by Moody’s Investor Services to near junk status as its implicit pension liabilities have swelled beyond the capacity to raise revenues. In Europe, Italy has recently bailed out its banking system by committing €17 billion. All these factors do not add up to a very promising outlook in the long run despite some positives in data.
In India, the yield differential between the 10-year and one-year government papers has been steadily declining from the beginning of this fiscal and now is in the range of 10-20bps. Short term rates are now determined by liquidity which has been in surplus mode since demonetization.
Long-term yields point towards declining inflationary expectations. A flattening yield differential makes the outlook on inflation and growth both uncertain, and this is exactly what this rate cut will correct in terms of correctly depicting the growth and inflation conundrums.
Regarding the domestic growth outlook, there is now unanimity that the capex cycle is weak and there is deceleration in output of infrastructure. Imports continue to grow, indicating import substitution. Thus, the overall picture that emerges is that there is little consumer or investment demand, and support to gross domestic product will come from government spending which may be already reaching a tripping point!
Coming to the observations on real interest rates, the markets may not be aware that RBI in its 2015-16 annual report had indicated that the risk free natural real interest rate for the fourth quarter of fiscal 2015 was in the range of 0.6% to 3.1%. Against this background, it is very likely that the last RBI assessment of 1.25% real rate may have further declined from such levels, given that growth is weak (real rate is business cycle sensitive). Also given the fact that RBI has reduced the repo rate to 6.0% and will keep consumer price inflation at 4% on a longer-term, real interest rate would be around 2%, which is at least 75bps higher than the earlier estimate.
From all these points of views, RBI has indeed room to cut rates.
Let me now highlight some other concerns on RBI policymaking apart from inflation forecasting errors. For example, inflation expectations play a key role in the deliberations of the monetary policy committee (MPC). However, there are inherent problems in such inflation expectation surveys that RBI needs to address on a priority basis.
In the Indian context, it has been observed that movements in inflation expectations are asymmetric, i.e., expectations ratchet up quickly when inflation is picking up but expectations are downward sticky when inflation is on the wane, and do not adjust to the extent of the decline in actual inflation. One plausible explanation for this could be risk aversion, i.e., India being a low-income country, people may be more prone to believe that any moderation in inflation is temporary and, therefore, they do not revise their expectation downwards. On the other hand, when inflation is rising, people panic thinking that the rise would be more durable and would erode their purchasing power considerably.
This is what the data in India actually shows. Actual retail inflation, as measured by the consumer index, has come down from a peak of 10.5% in September 2013 to 1.5% in June 2017, a fall of 900 basis points, while as per the three-month-ahead realized expectation, inflation declined from 11.4% to 7.5% (a fall of 390 basis points) and if we look at one-year-ahead expectations inflation declined from 13.2% to 9.6% (a fall of 360 basis points). Today’s inflation expectation data further substantiates our point. Clearly, expectations are asymmetric. Several high-income countries (including the US) demonstrate similar asymmetry.
The probable reason for this may be the way inflation expectation surveys are conducted or answered, particularly in India. People tend to go more by “inflation perception” rather than inflation expectation. Inflation perception pertains to the short term while inflation expectation is more long term in nature and the MPC must take this into account while making policy decisions.
We recommend that in Indian context for assessing inflation expectations, it may be more prudent for RBI to assess them from financial market instruments. In this regard, index-linked bonds may be the ideal candidate, although such bonds are thinly traded in the Indian market.
From a broader perspective, development of a futures market on both commodities and financial instruments may be a better indicator of inflation expectations.
Soumya Kanti Ghosh is group chief economic adviser, State Bank of India. Views are personal.