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Tuesday, September 28, 2021

No proof required: A data dependent MPC

In making the decision to cut the repo rate by 25 bps, the Monetary Policy Committee was neither dovish, nor hawkish, just pragmatic.

Written by Surjit S Bhalla |
Updated: October 8, 2016 12:37:31 am
Monetary Policy Committee, MPC, repo rate, repo rate criticism, what is MPC, what is repor rate, RBI MPC, reserve bank of india, RBI, urjit patel, rbi governor, ministry of finance, raghuram rajan, policy rate, CPI, CPI inflation, indian express column, india news, business The MPC is a new and progressive institution.(Source: C R Sasikumar_

The recent decision by the Monetary Policy Committee (MPC) to lower the repo rate by 25 bps to 6.25 per cent has been met with criticism and scepticism. Some analysts have gone as far as to assert that there has been faulty judgment.

This criticism and commentary is all part of a healthy democratic system. Also fair is that some critics (like myself) find fault with the criticism of the critics, and even find it unfair. As it happens, I also think that the RBI-MPC is unnecessarily using some very faulty tools. Just to put my cards on the table, I believe that the MPC and RBI Governor Urjit Patel have reached the best decision that was possible with the data they had. Historically, except for occasional lapses, the RBI has been a data dependent institution, and it is encouraging to see that the tradition is being strongly reinforced by the MPC.

Questioning of the MPC decision has proceeded along the following lines: First, and most importantly, that the inflation rate is too high to warrant a rate cut. The last four year-on-year headline inflation numbers have been as follows: 5.5 (April 2016), 5.8, 6.1 and 5.1 per cent (August 2016). The target of the RBI is five per cent for March 2017. So how can the MPC cut rates now, and that also with a unanimous vote?
Surely, and unlike Raghuram Rajan, the MPC is giving in to political pressure (Ministry of Finance) and major corporates (who always want interest rates to be cut). Further, the MPC is emphasising growth over inflation, that is, they have all turned doves.

It is likely that the unfortunate manner in which Rajan was not reappointed is colouring perceptions and interpretations of many commentators. For the fact remains that rather than being different than Rajan, the MPC (and Patel and RBI) are doing what Rajan would have done. How do we know that?

We know that from the second criticism by the “experts”. A popular conclusion of the experts is that the RBI has softened because it has reduced the real policy rate range from 1.5-2 per cent to 1.25 percent, that is the RBI was now targeting a 1.25 percentage points gap between the repo rate and CPI inflation. This was articulated by MPC RBI member Michael Patra in the press conference following the MPC decision.
So the experts are right in stating that the real policy rate is now 1.25 per cent.

But the experts are very wrong in deducing that this is a change in policy. Look at the following headline after the June policy meeting of the RBI under Rajan: “Will have room to cut rates if inflation stays at 5 per cent” (IE, June 9). The article goes on to quote Rajan: “If we get confident of achieving five per cent inflation target by March 2017, then we will get more space to cut.” What the RBI and MPC did on October 4 was a continuation of the RBI policy. There has been enough data on food prices, especially of pulses (and fruits and vegetables), to suggest that the next six-month course of such prices is at best stable at current levels, and likely to be lower because of the influence of good weather and increased acreage, and prospects of higher yields, for an “inflation-elastic” crop like pulses.

This assessment, and forecast, has no relationship with being dovish, or looking at growth more than inflation, or giving in to the demands of industrialists and/or the Ministry of Finance. Indeed, if the MPC members had not unanimously agreed to cut rates, they would likely have had egg (and worse) on their faces next week when the CPI data for September is scheduled to be released — a figure around 4.3 per cent year-on-year headline inflation will not be entirely surprising. The simple point is all of us are rightly expecting the MPC to be responsible — and when they do act responsibly, by cutting rates in the face of considerable evidence, let us not besmirch their honour, or intelligence, by attributing to them false motives.

But the MPC has room to improve. A central feature of all inflation targeting regimes, and all bankers, and all economists, is that the key to lowering inflation rates is the lowering of inflation expectations. In the case of already low inflation, the goal is to keep expectations stable. And as we now know for some developed economies (Japan, Europe), the key to successful monetary policy is to raise inflationary expectations.
In the first MPC-RBI policy statement, one finds the following statement on inflationary expectations, and how important and influential they are: “Households reacted to the recent hardening of food inflation adaptively and raised their inflation expectations in the September 2016 round of the Reserve Bank’s inflation expectations survey of households.”

Given the importance of inflationary expectations, one would think, and believe, that central bankers would strive to make sure that they measure properly such expectations. Or at least measure them to the best of their ability. It is not clear that the RBI has ever fulfilled this mandate. In January 2015, at the beginning of this rate-cut cycle, the RBI cited the results of its most recent inflation expectation survey (RBI-IES, December 2015), as supportive of a rate cut (25 bps from 8 to 7.75 per cent). This survey had shown a decline in one year forward expectations to 9.3 per cent from 13.5 per cent at the end of the previous quarter (September 2015). In my commentary on this rate cut (Indian Express, “Why ignorance is not bliss”, January 17, 2015) I had this to say: “Since when was high expectation of inflation of nine per cent low enough to warrant a rate cut? I fully agree that interest rates should be cut — but not because a junk RBI survey shows a decline in inflation expectations to a high nine per cent level. Better to junk junk than to offer it as an explanation — it makes all of us look bad”.

One and a half years later, and with an MPC in place, there is no change in this one bad habit of the RBI — the bad habit of using a junk survey, a junk result, to justify its otherwise very sound reasoning. Don’t take my word, or believe me, but do peruse the chart. There are two lines in the chart — actual year-on-year CPI inflation for each quarter, and the year ago forward expectation for the same quarter. For example, at the time Rajan cited the junk survey in January 2015, year-on-year inflation in 2014Q4 was 4.1 per cent. The forecast of the junk survey for this same quarter was 13.5 per cent!

Note also that there is no learning by doing on the part of the survey respondents. As inflation has declined, the forecast error (gap between forecast and actual) has widened, and to a near double-digit magnitude. It is intellectually embarrassing to even report these data, let alone use it.

The MPC is a new and progressive institution. The reasoning behind the vote, and the vote, of each MPC member will be made public 14 days after each meeting. We already know that it was a unanimous vote to cut. Let us hope that none of the members cite junk inflationary expectations.

The writer is contributing editor, The Indian Express, and senior India analyst, The Observatory Group, a New York-based macro policy advisory group

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