This government was supposed to be different. But just when one believes it is being different, it has the uncanny knack of rudely reminding us how close its thinking is to that of the previous government.
Take its position on the growth-inflation tradeoff. Less than four months back, in the full-year budget, the government undertook what has been its biggest and perhaps only structural reform so far. It exhorted the RBI to shift to a “modern monetary policy framework”. In the first policy review after the budget, the RBI obliged by adopting a quantitative inflation target (IT). The implications of this change could be far-reaching. History teaches us that chronic high inflation is eliminated by either moving to a fixed exchange rate regime (thereby importing some other country’s inflation) or by making the IT the sole objective of monetary policy.
So, after having persuaded the RBI to move to a “modern monetary policy framework”, is the government now uneasy about the straightjacket such a framework imposes on policy choices, or is it realising that it did not really intend for the central bank to adopt an IT framework? Either way, trying to push the RBI to cut rates by publicly urging it to do so may or may not hurt its credibility, but it raises questions about the faith the government has in its own policies.
The UPA often relied on such tactics to put pressure on the RBI. However, rather than growth being boosted and sustained, such efforts only led to inflation and inflationary expectations getting more entrenched. The RBI’s growth-inflation balancing framework meant that monetary policy was always forced to be reactive: if inflation surprised on the upside, policy was tightened; on downside surprises, it was eased. All this meant was that inflationary expectations were never anchored. When inflation dipped, the clamour for rate cuts heightened and the RBI reluctantly or willingly obliged, which ended up reigniting inflation a few months later.
In an IT framework, policy rates are determined by what is needed to reach the 6 per cent target on a sustainable basis, and not by monthly price volatility, unless the latter alters expectations of medium-term inflation. Thus, if the government truly believes that policy rates should be eased, it has to argue that the decline in oil and global commodity prices, fall in food inflation and lower-than-expected domestic demand will deliver an inflation rate comfortably below 6 per cent on a sustained basis. It can’t argue that monetary policy needs to be eased because that might be good for growth. This argument was taken out of the reckoning when the government exhorted the RBI to adopt the IT framework, and it obliged.
The question remains if the RBI should or will ease policy today or in the near term. While the probability of a cut today is low, not least because it could be construed as the RBI giving in to external pressures, it is hard to see policy rates remaining on hold over the next year. The decline in global commodity prices is here to stay over the medium term, given that China is structurally slowing, and there has been a significant increase in the global supply of oil. India, like many other emerging markets, has been importing disinflation because currency appreciation against the euro and yen has not been fully offset by depreciation against the dollar (that is, nominal and real exchange rates have appreciated on a trade-weighted basis and will likely continue to do so in 2015).
Despite the marked improvement in the plumbing of government decision-making, corporate India remains unconvinced of higher medium-term growth: industrial production continues to languish; credit growth is close to its lowest level in a decade; and investment growth again turned negative last quarter. The 5.3 per cent GDP growth last quarter was delivered largely on higher-than-expected agriculture and government spending. Both should trail off in the next quarters. Consequently, the near-term demand momentum could well disappoint again, keeping core inflation at bay.
Many have argued that policy rates need to be cut because real interest rates have risen sharply. This is a disingenuous argument. Real rates have gone up because inflation has declined, and almost all of the fall in prices is because of tumbling input , not output, prices. Consequently, the rise in real funding costs has likely been more than offset by the fall in other input prices, so that corporate margins have increased, not declined. Recent PMI data indicates this is exactly what’s happening. The urban middle class will also benefit not just from higher real deposit rates but also from the rise in purchasing power. The only group that stands to lose is the rural farming community because MSP increases have been significantly less than even the most optimistic inflation forecast. But this has little to do with real interest rates and monetary policy.
How does one determine whether real interest rates are too high and need to be eased? We all have different explicit or implicit inflation models that are often based on smell tests or dubious econometrics. Centering a conversation with the RBI on such disparate models would be talking at cross-purposes. More efficient would be to focus the discussions on the RBI’s own inflation model, which was discussed in detail in its September review. At that time, the RBI indicated that its model was forecasting inflation to be on track to print at 7 per cent by January 2016 — 100 basis points higher than the 6 per cent target. This computation was based on the assumptions prevailing then. Using the published sensitivities to different shocks to the model, a sustained $30 per barrel reduction in oil prices lowers the 7 per cent inflation forecast to about 6.5 per cent. To push the forecast comfortably below 6 per cent, one needs not only the current decline in food inflation to sustain throughout next year, but also for 2015-16 growth to be 100 basis points less than the RBI’s own forecast of 6.3 per cent. Informed dialogue on the likelihood of this and other scenarios is the right way to engage and challenge the RBI.
So when should the RBI ease? When it is convinced that from 2016, inflation will be comfortably below 6 per cent. This will likely mean that the RBI will wait until next year’s budget is presented and the current commodity and food disinflation show firmer signs of sustaining before cutting rates. But when it does cut, it is likely to do so decisively. The shift to the IT framework is the single biggest structural reform undertaken by the new government. It has given the economy a real chance to end chronic inflation and move to a sustained path of recovery. Giving this up for some perceived gain in near-term growth would be repeating the same mistakes of the past five years.
The writer is chief Asia economist, J.P. Morgan. Views are personal
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