Column: Monetary policy at an inflexion point

Written by Samiran Chakraborty | Updated: Jan 28 2014, 11:04am hrs
The importance placed on and excitement around the January monetary policy review has gone up a notch following the Urjit Patel Committee recommendations regarding the overhaul of the monetary policy framework. Earlier, markets were tracking the three conditions outlined by the RBI Governor in the December policy to build their expectations around the rate decision. At that time, the Governor had said that RBI will hike rates in the January policy (or before) if the following three conditions are not met:

*a significant reduction in the headline CPI,

* fall in core-CPI and,

* core WPI falling as well.

The December inflation prints (released in January) gave a mixed picture around these conditions and while the markets were busy in the guessing game, the Urjit Patel Committee recommendations have further added to the confusion on what RBI could do on January 28.

First, let us take stock of what is happening on inflation. Headline CPI in the December print (9.9%) is now marginally below the October print (10.1%). The cyclone Phailin effect, which took the November CPI up to 11.2%, has faded out. Vegetable prices have dropped 18% m-o-m and we expect further drop in the January print. The fall in the headline inflation print is no doubt significant and, with a visible downward trend in the near-term, RBI is likely to believe that the disinflationary process is on. However, the core prints on CPI and WPI appear to be sticky. In fact, there is a marginal uptick in the December print, which goes against the preconditions set by RBI. These opposite trends in the inflation data provide the opportunity to RBI to either pause or hike. In our view, the optically larger fall in headline CPI is likely to nudge RBI towards a pausegiving the slow growth process some more time to bring down core inflation.

However, the Urjit Patel committee report on the proposed monetary policy framework has brought us at an inflexion point on monetary policy although there is uncertainty around how many of the proposals will be accepted by RBI in this policy itself. It has no doubt recommended the most significant changes to the policy framework since 1998, when India transitioned from money supply targeting to a multiple indicator approach (with interest rates adopted as a monetary policy tool). The proposed flexible inflation-targeting framework switches the monetary policy decision from being discretionary to rule-based, using a single nominal anchor of headline CPI inflation. Under this framework, the committee expects RBI to bring down CPI inflation gradually to 4%. The near-term goalposts are at 8% and 6%, respectively, at the end of the next two years.

The choice of headline-CPI as the nominal anchor, if accepted, would demonstrate RBIs resolve to tackle the broadest measure of inflation which affects inflation expectations more directly. Also, the flexible inflation-targeting regime will result in more predictable monetary policy, particularly because the confusion over the choice of the inflation metric and the comfort zone of RBI on that inflation metric will be resolved. In our view, the CPI inflation targets proposed by the committee are challenging but realistic.

Over time, RBI is likely to accept most of the committees suggestions on the flexible inflation-targeting framework. However, convincing the political set-up of the need to focus solely on inflation might not be an easy task. That makes us uncertain about how quickly this framework will be formally adopted but RBI can quite easily communicate its intention to focus on headline-CPI.

The other concern is the ability of RBI to address recurrent food inflation arising from supply-side bottlenecks and market inefficiencies. Without direct control over food price movements, RBI has a limited ability to address inflation expectations by simply forward guidance on the inflation path. Until the supply-side issues are addressed, the focus on headline-CPI might keep policy rates elevated for a long period without the desired impact on inflation.

Some pre-conditions set by the Urjit Patel Committee for administering the inflation-targeting framework might also be difficult to meet. For example, the pace of fiscal deficit consolidation and the move away from administered prices are political decisions over which RBI has little control. RBI may not wait for all of them to be met before adopting the new framework, hoping that the government will slowly take the required steps to meet them. In such a scenario, it will be challenging to maintain the transparency and credibility of the new framework because the targeted glide-path on inflation might not be achieved.

An early adoption of the Urjit Patel committee suggestions increases the chances of a rate hike in the January policy. Our hope is that RBI decides to wait for the underlying disinflation process triggered by the lagged impact of earlier rate hikes to play out before tightening policy further. At the least, if the proposed monetary policy framework is adopted, we see little scope for rate cuts in 2014. Only if the headline-CPI inflation dips below 8% and moves towards the next target of 6%, the chance of rate cuts will arise.

The author is managing director & regional head of research, South Asia Global Research, Standard Chartered Bank