No proof required: Case for an inter-meeting rate hike

A ‘rate hike in time is just fine’ is a wise RBI saying. With CPI inflation at near-historic lows, this must mean, according to the RBI law of mean reversion, that the future will bring high inflation. Hence, the urgent need for intervention

Written by Surjit S Bhalla | Updated: March 18, 2017 12:16 am
RBI, RBi monetary policy, WPI infaltion, monetary policy committee, MPC, Reserve Bank of India, Urjit patel, RBI governor, RBi governor Urjit patel, CPI, MPC meetings, RBI news, india news, indian express news If Modi does not do large “in the name of the poor” deficit spending a la the Congress, he will be in danger of being accused of “suit-boot ki sarkar” by Rahul Gandhi and will likely lose the 2019 election. Illustration: C R Sasikumar

At the February 8 Monetary Policy Committee (MPC) meeting, the RBI surprised the world, and itself, by keeping the repo rate constant at 6.25 per cent — and by changing the policy stance to neutral from accommodative. Many (all?) criticised this decision as not grounded in economic reality; indeed, I titled my criticism ‘Jaywalking at the RBI’ (IE, February 25).

Economic and political events over the last month suggest that the RBI was right, and the critics wrong. Through this article, I tender my apology to the RBI for not seeing how right they were in their decision. Indeed, the data suggests that the time has come for the RBI and the MPC to raise the policy rate by 25 bp to 6.5 per cent. Recall that unexpectedly, the RBI reduced the repo rate to 6.25 per cent in October 2016, presumably much against its own instincts and under pressure from the ministry of finance. At both the post-demonetisation meetings in December and February, the RBI boldly asserted its independence from the Modi government (and from the world) by not cutting the policy rate any further. It can now fulfil its independence mission by raising the policy rate back to 6.5 per cent: The best way to do it is obviously via an inter-meeting rate hike — as the old Indian saying goes, why wait until tomorrow for what you can do today.

Here are the events, and data, that make a compelling case for the RBI to raise policy rates. First, the BJP has surprised all by winning in Uttar Pradesh, and forming a government in four of the five states that went to the polls. This has considerably reduced political uncertainty and provides Prime Minister Modi a free hand to pursue populist policies. Extravagant deficit spending in the name of the poor is a near certainty and the RBI showed extraordinary foresight in anticipating this reality at the eventful February MPC meeting. Prime Minister Modi knows how exceedingly successful populist spending was for Sonia Gandhi and Manmohan Singh in the 2004 to 2008 period; populist spending allowed the Congress to go from 145 Lok Sabha seats in May 2004 to 206 seats in 2009.

If Modi does not do large “in the name of the poor” deficit spending a la the Congress, he will be in danger of being accused of “suit-boot ki sarkar” by Rahul Gandhi and will likely lose the 2019 election. And we all know what this deficit spending can do — it will raise inflation to double digit levels, as happened in India during 2007-2013, an average of 9.4 per cent per annum for seven years. India cannot afford that experience again. What can help put a dent in that scary prospect? An immediate rate hike by the RBI.

The second reason for raising the repo rate — high inflation signalled by the Wholesale Price Index (WPI). Prior to the change brought about by former RBI governor Raghuram Rajan in 2013, India had used the WPI as its primary indicator of inflation. All the serious RBI research over the last sixty-odd years was based on the WPI; rumour has it that Rajan brought about the change to the CPI over serious objections from RBI staff who had made a career out of examining minutiae in the WPI innards. And Rajan snatched the WPI toy from RBI staffers. How would your 10-year-old feel if his action figures were taken away, without reason, and he was told to go read Harry Potter?

The WPI for February 2017 has come in at 6.6 per cent, the highest in the last 41 months: Just the previous month, WPI inflation was 5.3 per cent. An acceleration from 5.3 to 6.6 per cent in the RBI staff-preferred indicator, that too, in just one month? What more evidence is needed to prove the RBI assessment right about impending, and galloping, future inflation?

Third, notice how wrong the CPI is as an indicator of inflation. While the WPI has been exponential in its rise, the CPI has been exponential in its decline — CPI inflation has averaged less than 4 per cent for each of the last four months and is likely to do the same for March 2017. Only as recently as December 7, 2016, the RBI, anticipating Modi’s victory in UP and near-double digit WPI inflation, said in its Policy Statement that CPI “headline inflation is projected at 5 per cent in Q4 of 2016-17 with risks tilted to the upside”. It is very unlikely that the Jan-Mar 2017 CPI inflation will be much different than 3.5 per cent — almost 150 basis points below the RBI forecast of 5 per cent plus made just two months ago. However, this low inflation reality is not necessarily indicative of the RBI being grotesquely wrong in its very short three-month inflation forecast. For, as the inflation experts at the RBI will no doubt educate us, CPI inflation follows WPI inflation with long and variable lags, and so, CPI inflation will traverse above 5 per cent very soon. And it is the future RBI expectations on which RBI policy is based.

Also, adding to the prospects of higher inflation in the future is the fact that true core inflation (CPI inflation minus food minus fuel and minus petrol) has come in at 4.22 per cent in February, the lowest level since the 3.7 per cent registered in June 2008, some 103 months ago. In the February MPC meeting, the RBI had emphasised how sticky core inflation had been. Core inflation has been anything but sticky; more like a steep slide. Also aiding the RBI assessment of inflation in India is the value of the Indian rupee — at 65.3 per dollar, this is the strongest level since October 2015. Whatever goes up must come down is the best forecast one can make about the rupee — and the reverse for core inflation. Central Banking 101 — bet on mean reversion! The MPC has to act according to its perceptions of the future; very likely the RBI is viewing this strength in the rupee, and trend decline in core inflation, as something that has run its course and should soon be reversing.

In addition, the US FED just raised rates by 25 bp and warned they might raise the US Fed Funds rate by another 50 bp over the year. Isn’t it a “historical fact” that if US short-term rates go up, Indian rates must go up by at least the same amount— else we will have capital fleeing the country, as Indians find it worthy to invest in 2 per cent yields in the US, rather than the 7.5 per cent yields obtained in India A “rate hike in time is just fine” is a wise RBI saying. No matter what set of data one examines — political uncertainty, populist spending, WPI inflation, CPI inflation, CPI true core inflation or US fed funds rate. All data point to the urgent need for the RBI to raise the repo rate by a minimum of 25 bp with immediate effect. India is fortunate to have an MPC that truly looks ahead, correctly anticipates the future and always acts in the best interests of the economy, and the nation.

Surjit S Bhalla is Contributing Editor, ‘The Indian Express’, and Senior India Analyst at Observatory Group, a New York-based macro policy advisory group. Views are personal

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  1. K
    K SHESHU
    Mar 18, 2017 at 2:15 pm
    Whether CPI reflects or not, present state of inflation may be a danger to future econoic growth m
    Reply
    1. T
      Truth
      Mar 17, 2017 at 8:54 pm
      The "Drama" behind RBI's intervention - lt;br/gt;lt;br/gt;On 8th November 2016, the P M asks the RBI Gov. U. P. to jump into the well...lt;br/gt;U. P. jumps and takes with him the RBI and the economy....lt;br/gt;On 9th November, U.P. realizes his mistake and tries to come out...lt;br/gt;He finally comes out with the RBI on 31st December after 100 reversals....lt;br/gt;He is now desperately trying to fish out the submerged economy....lt;br/gt;U.P., F M, and the P M have yet to give the "correct" data on GDP and DeMon...lt;br/gt;lt;br/gt;Till then the "Drama" will continue !
      Reply
      1. M
        Mahender Goriganti
        Mar 18, 2017 at 2:40 am
        Once again the Islamic Express armchair pundits all over with their gospels like form Mullahs and Moses as acts and Dharma.
        Reply
        1. R
          Ramesh Chhabra
          Mar 18, 2017 at 3:21 pm
          Demonetization is an "Agaz" of future inflation(s).
          Reply
          1. S
            shiravanthe sridhar
            Mar 18, 2017 at 6:21 am
            Your attempted drama with words is more in vain than RBI,PM's put together ad it is clouded by your incurable congenital allergy of MODI BJP RSS.
            Reply
            1. D
              Dr.SHIVAJI
              Mar 18, 2017 at 10:24 am
              With great respect to Surjit bhalla it seems to me that u had taken neutral stance along side the RBI last time in cising Apex regulator for not reducing policy rate, n now you are asking to raise it...With humongous data analysis u ,pretend yourself to be trustworthy and all insution thereby must fall in line with your opinions...How fair is to trust now? it's beyond my imaginations...And for God sake don't criticise Raghuram Rajan n the reason i know .....but please...
              Reply
              1. V
                v b
                Mar 18, 2017 at 2:00 pm
                RBI and MPC seem to rely too heavily on CPI in determining the interest rate stance making it off the mark. The reason is: the measurement of CPI is perhaps itself faulty. Movements of CPI--even what is referred to as core CPI--give unreliable signals. Some of the reasons for the measurement of Core Inflation proving to be faulty are as follows. Firstly, the prices of services are not included in measurement of inflation. Secondly, The effect of “money illusion” makes the prices of services to remain static at current levels once they go up in line with prices of goods and money prices of most services do not go down when prices of goods go down. Thirdly, the sampling process applied to collection of data of retail prices of goods is flawed. Fourthly, the weights applied in computing the index undergo frequent change as new types of goods (e.g., Smartphones) emerge in the market. lt;br/gt;A cut in interest rates results in drop in the incomes of savers and depositors who are not so vocal and influential as the borrowers the largest of them being the Government itself. A cut is not to be allowed on the basis of such unreliable metric as it affects the lives of too many savers and depositors.
                Reply
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