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Business News/ Opinion / Columns/  Opinion | Seven key reasons for RBI not to shift its policy stance

Given the recent sharp increase in retail inflation, markets seem to be worried about the potential reaction of the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), particularly its stance on monetary policy. Some market participants have started considering the possibility that the MPC could change its stance from accommodative to neutral in its 6 February policy, citing discomfort with the latest inflation figure. While this possibility cannot be ruled out, there are several reasons why switching to a neutral stance would be premature.

A neutral monetary policy stance at this stage may not be appropriate, as the government has little space on the fiscal front to support growth. The primary risk to the Indian economy is still biased towards a prolonged growth slowdown, rather than a structural move upwards in consumer price inflation.

The MPC should wait for more evidence on food price trends before shifting its stance to neutral. It is evident that RBI will have to increase its quarterly inflation forecast once again this month, though the upward revisions made in its December policy were quite substantial. While it is certain that food inflation, particularly related to vegetable prices, cannot sustain at these levels and a course correction is overdue, it is difficult to predict how quickly and how sharp the reversal is likely to be over the next few months. The April policy would be an appropriate time for the MPC to consider whether to change its stance or not, based on the evolving growth-inflation trend till then.

An early shift in stance to neutral may result in the fear of potential rate hikes in the near future. The central bank had provided a guidance of keeping “rates lower for longer" as early as in October 2019 and, therefore, changing its stance in a span of just four months may prove to be too hasty. It would imply that the MPC could also consider hiking rates at some later stage, instead of the other two alternatives of maintaining a status quo or easing rates further. Given the current uncertainty over the near-term inflation outlook, markets might start placing greater weight in their estimations on the central bank considering a rate hike, rather than a cut, thereby leading to upward pressure on market interest rates.

A large negative output gap and financial market vulnerabilities point towards the need to persevere with an accommodative stance. India’s actual output is estimated to be more than 2 percentage points below its potential at this stage, with a growth recovery expected to be shallow, given the ongoing problems in the credit market and the general risk aversion that persists in the economy. Against this backdrop, one would not expect core inflation, calculated without volatile fuel and food prices, to pose a material threat to overall inflation. India needs a lower cost of capital to provide stability to the economy and incentivize fresh investments and consumption growth. A premature change of stance to neutral, by opening up the possibility of higher interest rates in the quarters ahead, might result in a slower-than-anticipated growth recovery.

A premature neutral stance, with its potential to drive market yields higher, could offset the reduction in bond yields achieved through RBI’s version of “Operation Twist". On 19 December 2019, RBI had first announced its decision to conduct market operations involving the purchase of long-dated bonds and the simultaneous selling of short-maturity securities, thereby both lowering yields at the long end, with bond prices pushed up by its buying, and pushing up yields at the short end, with bond prices dipping on account of its sales. This was based “on a review of the current liquidity and market situation and an assessment of the evolving financial conditions". The action has helped reduce pressure on longer duration bonds to an extent, without which yields would have surely been higher. However, a neutral stance could neutralize the effect. As it is, the transmission of previous RBI rate cuts remains incomplete and a change in stance to neutral could delay or stop any incremental easing of lending rates.

The inflation expectations of households would likely have risen further in the latest RBI survey, reflecting higher food prices, but will fall once food inflation eases. There is no need for RBI to react mechanically to the latest data and shift its stance. Food inflation, expected to peak in the first quarter of 2020, will probably go on a downtrend thereafter and household worries of food prices increasing will also ease with a lag, given the strong correlation between the two variables.

Another reason that the MPC should not hurry to change its stance to neutral is that wholesale inflation for manufactured goods and core wholesale price inflation are still in negative territory. According to the wholesale price index (WPI), manufactured goods inflation was at -0.3% year-on-year, while core WPI inflation was at -1.5%, with food items excluded. These figures indicate an acute weakness in the manufacturing sector. When RBI used to follow WPI inflation for its monetary policy, the aim was to keep core WPI inflation around the 4% mark, though there was no official targeting. Today, the MPC’s mandate is to target headline consumer price inflation, but members of the panel ought to consider the distress in India’s manufacturing sector before making any change to the policy stance.

Kaushik Das is chief economist, India, Deutsche Bank

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Updated: 04 Feb 2020, 09:40 PM IST
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