A cautious case for another RBI rate cut
The Reserve Bank of India’s monetary policy committee (MPC) should cut policy interest rates once again this week—even though the consensus view is that it will maintain the status quo.
The main issue that should concern the six MPC members right now is the unexpectedly sharp decline in economic growth in the first quarter of the current fiscal year. Growth in real gross value added (GVA) has dropped from 8.7% in the quarter ended March 2016 to 5.6% in the quarter ended June 2017. Nominal GVA grew at the lowest pace in seven quarters.
Panic is yet unwarranted. This newspaper believes that there will be a mild recovery in economic momentum as the transient factors that hurt economic growth in the three months to June begin to dissipate. A variety of high-frequency indicators show that aggregate demand began to recover from July.
However, this partial recovery should be seen against the backdrop of a larger slowdown in economic activity. MPC will also have to figure out whether hysteresis is setting in after the twin shocks from demonetization followed by the recent implementation of the goods and services tax (GST), as supply chains get disrupted. It is quite likely that the Reserve Bank of India will cut its forecast for economic growth this year, as many private sector forecasters and multilateral agencies have already done. Its industrial outlook survey also shows aggregate demand under pressure. A reduction in the official growth forecast by the Indian central bank should be seen as an indication that the output gap has widened, thus creating space for a rate cut.
The inflation outlook is a relatively less serious concern right now, despite the sharp bounce back in price momentum from the unnatural lows of June, led by the recovery in some food items. Core inflation is at a comfortable level. Most professional forecasters continue to predict that inflation a year from now will be close to the inflation target. It is worth reiterating once more that a central bank that targets inflation considers the inflation forecast as its intermediate policy target, a natural requirement given the inevitable lags, and not the inflation experienced in the past months. Too many analysts miss this central point in the new monetary policy framework.
There are two factors that cloud the inflation outlook. First, inflation expectations of households had begun to pick up despite the fall in headline inflation, perhaps because expectations continue to be adaptive. The results of the next round of household surveys deserve close attention. Second, the doubling of house rent allowance (HRA) for central government employees will lead to a statistical boost to inflation from August till perhaps December. State governments will follow. The MPC should look past this one-time shock, since it will not lead to any permanent impact on inflation dynamics.
This newspaper has generally been hawkish on monetary policy. India has struggled with high inflation over the past decade even as the rest of the world has experienced low inflation. The need for conservative monetary policy was even more important given the reckless fiscal spending that we saw after 2008. Policy credibility was undermined.
So our call for another rate cut continues to be a cautious one—especially given the political incentives for fiscal adventurism in the months leading to the next national elections due in early 2019. The Narendra Modi government has till now done well to secure macroeconomic stability, but what it does in the coming months as the drumbeat of criticism grows louder is still not clear. The global economy also needs to be considered. Economic growth in many major economies is strengthening, but the decision of the US Federal Reserve to reduce its balance sheet through quantitative tightening could unsettle capital flows.
RBI broadly considers a real interest rate of 1.5% as the equilibrium rate necessary to keep the inflation-growth mix near target. Of course, this number is not cast in stone; it should ideally change depending on the state of the business cycle. The 1.5% real interest rate is also the rate at which households have ample incentives to save in financial rather than physical assets.
The Indian central bank thus has space for another 50 basis points of cumulative rate cuts. There is no case for drastic action, especially if the policy stance continues to be neutral rather than accommodative. The question is how RBI should use the firepower that is left in its armoury. We believe it makes sense to use 25 basis points right away and keep some powder dry for early 2018.
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