Photo: Bloomberg
Photo: Bloomberg

Thinking about the repo rate

If fiscal and food price policy is supportive, monetary policy should aim for a neutralnot a tightstance

Indian aggregate demand (AD) is weak, with growth much below potential. Industry has not really picked up, since investment and consumer demand have not revived. Moreover, global demand is weakening. A slowdown in Europe which has the highest share (18%) of Indian exports tends to reduce export growth.

Inflation, however, is reducing due to a number of factors. The softening in global oil and other commodity prices is likely to sustain; the exchange rate, more or less stable since September 2013, has reduced imported cost-push inflation; the government is committed to reducing the fiscal deficit and is restructuring its expenditure from consumption towards investment, it has also kept the rise in agricultural minimum support prices low; since food inflation has reduced to below double digits wage growth is moderating. Some productivity increase in agriculture should absorb nominal wage indexation without leading to second round effects. The indexation will also prevent over-reaction in wage increases.

The fall in core consumer price index (CPI) inflation from a sticky 8% to 6% implies it was not excess demand but the food price-wage cycle that kept it high. That there is no seasonal base effect on core CPI, suggests the fall in inflation may be persistent. There is a view that since the Reserve Bank of India (RBI) can only affect AD and not supply, it needs to continue to squeeze AD to reduce inflation. But estimations show the output gap has a low effect on inflation. Therefore this strategy of reducing inflation has a high output cost for little effect on inflation.

What RBI does also affects the supply-side, however. So it has other weapons against inflation, such as anchoring wage-price expectations that feed into costs. But again estimations show the policy rate has only a mild impact on informal-sector wages. Food prices affect inflation expectations more than interest rates do. So provided fiscal and food price policy is supportive, monetary policy can be at the minimum of the range necessary to help anchor inflation expectations. That is, it should aim for a neutral—not a tight—stance.

Other considerations support this conclusion. First is the principle of allocating an instrument to the objective it is most effective in meeting. Interest rate affects investment, consumer durable and housing demand, and raises production costs. The interest elasticity of AD is appreciable. Food price policy directly affects food price and wage inflation, while government consumption and social expenditure increases the demand for a diverse food basket. So as moderation in these two reduces food inflation, monetary policy can moderate its demand squeeze. This policy package would anchor inflation expectations at the least cost in output foregone.

Second, estimations show the share of prices set in a backward-looking fashion is about 80%. The low forward-looking component reduces the need for a large response of policy rates to inflation. Policy rates need to change slowly to the extent inflation comes down slowly. It also implies responding to current AD should have priority over responding to the low share of forward-looking inflation expectations. Mechanical policy rules that ignore context have been shown in the literature to lead to instability. Third, economies such as India are subject to repeated supply and external shocks. If they are expected to have persistent effects on inflation, policy rates have to respond to them. Since shocks make forecasts of inflation less reliable, policy rates are more dependent on current data. If rates could move in either direction in response to a shock, policymakers cannot afford to keep waiting for perfectly anchored inflationary expectations. Since an unexpected shock can force them to change direction, time-dependent one-sided guidance is not credible and therefore less effective. The 2013 taper-on (US Federal Reserve winding down its bond-buying programme) shock is an example where the policy stance was reversed due to an external shock.

But what is the neutral policy rate? Spreads over policy rates are high in India, and very low manufactured price inflation means firms face high real interest rates if policy is targeting much higher consumer price inflation. Moreover, if AD is below potential output equilibrium real interest rates fall. So the neutral real interest rate policy should target at present is zero. Some weight on output is consistent with the flexible inflation targeting policy is moving towards. Since headline consumer inflation forecasts for 2015 are now tracking 6% consistent with the glide path announced, policy repo rates should very gradually move downwards. In any case, banks are beginning to cut rates since the supply of credit much exceeds the demand for it at the current interest rate structure.

A recent International Monetary Fund (IMF) study says the Indian real interest rate should be positive at 1.5%. Since they see headline consumer prices as sticky at 6.5% the policy repo rate should continue at 8% for a long time. The above arguments suggest this logic is flawed. Following IMF suggestions is dangerous since it tends to prescribe harsh medicine for emerging markets while being soft on advanced economies. It neglects high Indian unemployment since it is poorly measured, while focusing on that in advanced economies, although Indian unemployment is actually higher.

The IMF prescription would maintain high interest differentials that attract debt inflows. These can suddenly reverse, leading to large currency depreciation. This is what happened to East Asia when it followed incorrect advice, during the late-90s crises. Debt flows have been the largest share of inflows into India during the past year, and Indian firms are building up unhedged currency risk just as East Asian firms did.

Ashima Goyal is professor of economics at the Indira Gandhi Institute for Development Research.

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