It is now time for an RBI rate cut
But the claims that lower interest rates will kick-start the investment cycle are less tenable
There is a compelling case for the monetary policy committee to cut interest rates when it meets this week.
This newspaper has generally been conservative on these matters because of the inflation bias hardwired into Indian macroeconomic policy. The best indication of inflation bias is the rapid increase in prices since 2008, despite the fact that most large economies have flirted with deflation. India has been a global outlier. Monetary policy has had to be asymmetrical to quell the persistent inflationary fire.
The recent decline in inflation appears to be structural in nature, as is evident from the trend in headline inflation, core inflation and inflation expectations. HSBC economists Pranjul Bhandari, Dhiraj Nim and Aayushi Chaudhary show that the inflation differential between India and the rest of the world has narrowed on a sustainable basis. Disinflation is the result of a combination of factors: prudent monetary policy, modest increases in minimum support prices and the downturn in the global commodities cycle.
The decline in inflation should be seen in tandem with the widening output gap, or the difference between the rate at which India could potentially grow and the rate at which it is actually growing right now. The best indicator of this in our view is the trend in the core gross value added, which captures private sector activity better than the headline gross domestic product numbers. So, the inflation trajectory on the one hand and private sector production trends on the other hand suggest that it is time for a rate cut. However, the claims that lower interest rates will kick-start the investment cycle are less tenable.
The caution displayed by the Reserve Bank of India (RBI) in recent months has come under a lot of criticism. It is worth bringing an important principle in monetary policy into the public debate at this juncture. In a landmark paper written in 1967, which has often informed global central banking practice, William C. Brainard argued that monetary policy should be conservative when faced with uncertainty. The Brainard principle resonates in these times as well.
The Indian central bank would have erred in rushing into a hasty rate cut when faced with multiple uncertainties — and multiple exogenous shocks — over the past few quarters. These uncertainties seem to have receded. It is now more clear than before that food prices have not retreated only because of the disruption due to demonetisation. The transition to the new goods and services tax (GST) seems to be a smooth affair. The monsoon has got off to a good start. The US Federal Reserve may go slower than expected when it comes to whittling down its bloated balance sheet.
Our call for a rate cut continues to be a cautious one. Too much of the noisy public discussion is focussed on the June inflation number, which was 2.5 percentage points below the lower bound of the range the RBI is committed to. It is important to remember that a modern central bank seeks to stabilize inflation over the medium term. The monetary policy agreement explicitly says the Indian central bank would have failed to meet its target only if inflation stays outside the accepted range for three quarters in a row, rather than any single month.
Most private sector forecasts over the next 12 months seem to suggest that inflation will be a little above 4% a year down the line, or very close to the central point of the inflation target. That seems like a reasonable call. These inflation forecasts serve as the intermediate target of Indian monetary policy, given that changes in interest rates affect the real economy with a lag of around three quarters. (The paradox of aggressive rate cuts when there is so much excess liquidity in the money market also needs to be taken into account.)
The key challenge continues to be the anchoring of inflation expectations. Even if one for now keeps aside the valid complaints about how inflation expectations are measured in India, there is no doubt that there has for too long been a yawning gap between the inflation expectations of Indian citizens and the inflation target of the RBI (either the informal target earlier or the formal one now). This gap is a sign that the credibility of the Indian central bank suffered because of years of high inflation. Anchored inflation expectations will eventually allow policymakers to look past temporary economic shocks, since wage demands will be stable once people have confidence in the ability of monetary policy makers to keep inflation near target over the medium term.
India has entered a welcome stage of macroeconomic stability thanks to prudent policies over the past few years. Sustainable economic growth comes against the backdrop of such stability—plus economic reforms —and not from hasty stimulus policies.
Does the decline in inflation justify a rate cut? Tell us at firstname.lastname@example.org
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