Opinion
Why the MPC should slow its pace of tightening
Summary
- Comparisons with targets and past 10-year averages show inflation in India is less of an outlier than in many rich economies.
The six members of the Indian monetary policy committee (MPC) are scheduled to meet early next month to decide the next move in policy interest rates. They have quite correctly increased the benchmark repo rate by 190 basis points since May, as a recovery in economic activity allowed policymakers to focus more on the challenge of rising prices. Monetary conditions have also become tighter since the evaporation of excess liquidity in the money market, led by a sharp fall in foreign exchange reserves. The Indian central bank was perhaps a bit slow to pivot towards a greater focus on inflation, but that can be said about many of its peers across the world.
There is now a growing case for the MPC to either take a pause in December or announce a very modest interest rate hike. The second option is better, since it would signal that the battle against inflation is still not over, which a pause may be interpreted as. The MPC meeting in October has already revealed an important difference of opinion in the group. It will be worth seeing next month whether or not more members come around to the view that it is prudent to watch how interest rate hikes in recent months have been curtailing domestic demand, rather than maintain the recent pace of rate hikes.
Monetary policy affects real economic activity with a lag of three or four quarters, so the intermediate target of monetary policy is the inflation forecast, or where inflation will be a year down the line, rather than where it is right now. Economists at the Indian central bank expect consumer price inflation to come down to 5% by the middle of 2023, which means that the real policy interest rate is already 90 basis points above the inflation forecast. However, it is not prudent to depend too heavily on the inflation forecast at this juncture, since the Reserve Bank of India (RBI) has made forecasting errors in recent months.
A more useful argument in favour of a slower rate hiking cycle, if not an outright pause, is that there is not enough evidence as yet that the spike in inflation has had significant second-round effects, unlike in many rich economies. These second-round effects of inflation—or the amplification of price shocks—usually happen through either the labour market or corporate pricing power.
The Indian labour market still has slack, especially if we look at the labour force participation ratio rather than the unemployment rate calculated every month by the Centre for Monitoring Indian Economy. Wage growth is likely to be muted in such a labour market. On the other hand, companies have greater pricing power now because of the multiple shocks to small and informal enterprises over the past five years. The business inflation expectations index from a panel of companies surveyed by the Indian Institute of Management, Ahmedabad, show a decline.
How does Indian inflation compare with the price situation in other major economies? And what lessons can Indian monetary policy analysts draw from it? In the chart shown here, I have used data from the 12 largest economies in the world to calculate two ‘distance measures’. How far is current annual inflation in each economy from either the official or unofficial inflation target? And how far is inflation in 2022 from the average of the previous decade (i.e. 2011-2021), in terms of standard deviations?
The numbers show that the Western world, which chose oversized stimulus packages during the worst months of the pandemic, are in the midst of full-fledged inflation shocks. For reasons specific to each country, India, China and Japan are better off. A good thumb-rule is that countries with greater distance from their inflation targets as well as past inflation need to react more strongly to price pressures than countries where the distance is smaller. For example, the US has more reason to push its real interest rate beyond its estimated neutral interest rate than India does right now.
That said, the tricky bit for the Indian MPC is to figure out whether it wants to use the interest rate solely to target inflation, or also use it to manage the exchange rate as well as financial stability. Economic theory tells us that each policy instrument should ideally be matched with one policy target. But, as J.P. Morgan’s chief India economist Sajjid Chinoy has argued in a recent piece, there are feedback loops between internal and external macroeconomic stability. Ideally, RBI should manage the exchange rate by using its foreign exchange reserves, but the sharp fall in its war chest during the recent defence of the rupee means that the interest rate tool will have to be used for inflation control as well as curbing volatility of the exchange rate.
Indian monetary policy easing began in early 2019, when the repo rate was 6.5%; the pace of easing quickened after the pandemic struck in early 2020. The repo rate is now 60 basis points below its recent peak and 190 basis points above its pandemic-time low. This is also a useful context to think about the pace of monetary policy adjustment from now on.
Neha Jain assisted in the data analysis for this article.
Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.
