Photo: iStock
Photo: iStock

Opinion | There’s more that RBI needs to think about than just rate cuts

Given the economic slump, it should review whether its neutral real interest rate and inflation target need to be recalibrated

The puzzling price trends in China should resonate with the six members of the Indian monetary policy committee (MPC) when they meet in early December to decide their next move. Chinese producer prices fell the most in three years in October, while consumer prices went up at the quickest rate in eight years. Core inflation was under control. The sharp increase in consumer price inflation in China is largely explained by soaring pork prices.

There will be a similar inflation divergence in India that the MPC will have to grapple with. Wholesale price inflation is likely to slip into negative territory in October. Core inflation will be close to deflation territory because of weak aggregate demand. Meanwhile, consumer price inflation will overshoot the central point of the inflation target given to the Reserve Bank of India (RBI).

Headline inflation has been steadily increasing this year—from 1.97% in January to somewhere around 4.5% in October. The MPC should look past this inflation data for three reasons. First, the spike in October will be driven by a rise in the prices of select food items such as onions, potatoes and tomatoes. Second, there were supply disruptions in some parts of India because of heavy rains. Third, average inflation for the year will still be below the inflation target.

Most private sector economists predict that inflation pressures will ease in 2020. The divergence in the different measures of Indian inflation has often been a flashpoint for debate. Does core inflation move towards headline inflation or is it the other way round? The record is confusing. In the early years of this decade, high food inflation eventually became generalized. Inflation spread from food to the rest of the economy. Last year, core inflation was well above headline inflation for many months. It eventually came down to meet the headline number rather the headline number moving towards core.

There is ample reason right now for the MPC to look past the expected spike in consumer price inflation, and focus on weak economic growth instead. The second quarter will almost certainly be worse than the first quarter in terms of economic growth, and consensus estimates for economic growth in the current fiscal have already been downgraded to around 5.5%. This column has earlier argued that the economy is likely to bottom out in the second quarter of this fiscal year, but the subsequent recovery will be a weak one. In a recent report, investment bank Nomura has estimated that the Indian economy will grow at only 4.9% in the current fiscal year, well below the consensus estimate.

However, there are two other important analytical issues that the Indian central bank should focus on in the coming months.

First, does the gradual decline in India’s potential growth rate mean that RBI needs to recalibrate its ideas about the neutral or equilibrium real rate of interest? The flexible inflation targeting framework has baked into it some estimates of the neutral real rate of interest, or the short-term interest rate that keeps growth at potential and inflation near the formal target.

The neutral real rate of interest is an unobserved variable, and also devilishly difficult to measure (if at all). This rate moves depending on the state of the business cycle as well as changes in the structural rate of growth. The RBI has, at different times, indicated that it works with a neutral real rate of between 1.25% and 1.75%. The sharp slowdown in India’s economic growth—partly structural and partly cyclical—should open a new debate on the equilibrium real rate. It should not be lower than what was earlier assumed. This has profound implications for monetary policy.

Second, should the new monetary policy agreement that needs to be signed by the government and RBI in 2021 continue with the existing inflation target, or some other variant? This is a deeply empirical question. The Urjit Patel committee had identified the threshold inflation rate for India—or the inflation rate beyond which price increases begin to harm economic growth—at 6%. That made it the upper end of the tolerance band. The global inflation rate of 2% was identified as the lower end of the band, given that India is an open economy. The mid-point of this range, 4%, was taken as the central target.

A committee headed by Sukhamoy Chakravarty had, in a 1985 report, also given an implicit inflation target of 4% to RBI, though it was in terms of wholesale prices rather than consumer prices. I recently looked at data from 17 large economies which have inflation targeting regimes. Fifteen of them had average monthly inflation lower than the target. India is in the majority. The only two exceptions were Mexico and Russia. The upshot: Most central banks are currently struggling with inflation that is lower than their respective targets, despite massive money creation.

The current state of the Indian economy calls for lower interest rates, despite a temporary blip in inflation. There should be two other analytical issues on the horizon—the equilibrium real rate of interest and whether a new inflation target is needed.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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