Column: RBI was right in ignoring market buzz

Written by Renu Kohli | Updated: Dec 24 2013, 05:40am hrs
RBIs decision to keep its policy rate on hold last week and rather wait for more price data is appropriate and welcome. Though this surprised markets, the central bank focused upon what analysts chose to not: that November headline inflation rates were a spike driven by vegetable prices, which was expected to correct sharply in December post state elections. Though it remained worried about rising headline inflation, the central bank rightly focused on the stabilising non-food, non-fuel (core) WPI and CPI inflation, which it expects to further moderate from rupee stability, a negative output gap and past monetary tightening. For this interplay to transpire, the central bank saw it optimal to wait for another data round in what was a close call. Should these data disprove its hopes, RBI will promptly act, even ahead of the scheduled January review. The question then is if twenty-five days are sufficient for such restraining effects to feed through into December inflation, subduing it enough for RBIs comfort Or should it wait a bit more perhaps

Consider its specific guidance on the three response parameters for this. First up, the expected softening of food inflation where RBI expects more contribution from central and state governments. Political economy makes it hard to predict movement on this front, especially in less than a month. But the declining trend in almost every item, including cereals, in the WPI and CPI food basket, for some monthsvegetables being the sole exception and culprit in July-Novemberwith some government action RBI took note of, there is reason to hope the past trend may sustain. Indeed, Decembers sharp correction in vegetable prices in itself could bring down headline CPI inflation into a 9% to 9.5% range.

Next, RBI will look for declining momentum in non-food, non-fuel or core inflation. WPI-core inflation rose a bit to 2.66% in November, from 2.64% in October, and a revised 2.52% and 2.29% in September and August respectively (provisional, 2.11% and 1.94%). But as provisional measures are often revised at two-month lag, and 35-41bps revisions were made to August-September numbers, it is reasonable to add about 40bps to October-November provisional measures. Thus a fair guess should place the revised core-inflation to a little above 3%, almost close to RBIs target. Even if December WPI core-inflation outcome is a little above 3%, the direction or decline in momentum should endure in this month as a stable rupee feeds through.

Core CPI-inflation stabilised a bit in November, to 7.97% from 8.05% and 8.37% in the preceding two months. Strangely unresponsive to past monetary tightening, its high level is at variance with all evidence pointing to extraordinarily weak demand conditions. It is extremely worrying why this does not reflect the deceleration dynamics observed elsewhere. Inter alia, this includes the negative output gap (1.5% to 2% is RBIs guess); rapid slowing of loan growth (14.2%, end-November) vis--vis deposits (16.1%); falling car sales, rising inventories, production cuts; sharp deceleration in services, and not just from fiscal compression but trade, hotels and restaurants, etc, where consumer spending reflects; prolonged feebleness of industrial output growth; and that past monetary tightening from September is yet to transmit across banksin fact, two banks which had earlier raised interest rates a bit, returned to earlier levels last week! None of these suggest workers negotiating higher wages, i.e., inflation expectations are getting realised. The sole exception is rural wages, which RBI noted having risen in October; this seems seasonal looking at past behaviourthe overall trend here too is of a decline from December 2011.

Two important points need emphasis on headline and core WPI-CPI inflation rates vis--vis further monetary action. One, the stickiness of core-CPI inflationRBIs preferred measure of second-round price effects transmitted from high food inflationrelative to measured demand indicators. This is a puzzle RBI must credibly solve: What explains the elevated CPI-core, comprising mostly services, which are seeing a sharp deceleration in the quarterly growth numbers The services sector is unlikely to suffer from supply constraints, the explanation for food inflation. Is a wage-price push explanation sufficient when the same isnt true for the manufacturing segment Can we rationally explain this behaviour If not, is the new CPI-core overstating true inflation Housing rentals, for example, which are imputed prices with a 9.77% weight, are observed rising over 10% each month in such economic conditions. Such inexplicable dynamics can be a stumbling block for RBI when it looks for disinflationary effects from a negative output gap, slowdown in services growth and lagged effects of effective monetary tightening since July, in about three weeks from now.

Two, the RBI Governor mentioned four inflation targets in his post-policy conference: Headline WPI below 5%; core-WPI below 3%; and developing targets for CPI and its core element with help from the Urjit Patel committee report (to be submitted end-December). This is confounding and potentially dangerous. Consider a hypothetical situation wherein headline CPI inflation falls in December to say, 9.5%; core-CPI declines to 7.8%; headline WPI inflation falls to 6.5%; but core-WPI inflation steps out of the 3% bound. Which target will RBI respond to, what is the deviation, if any, it will tolerate This is a recipe for enormous confusion. Markets react to numbers, of which RBI is dishing out four! The central bank should consider whether existing uncertainties should be multiplied so.

Should inflation outcome not conform to the interplay expected, it will act promptly, said RBI in an obvious reference to January inflation data release dates. Any further monetary action will be accompanied by revised inflation projections as well, since RBI had completed this for the year in October, based upon its then-inflation forecasts for end-March. The implicit view in that case would be that GDP growth is higher than measured reading. Will RBI revise its growth forecast, currently 5%, accordingly Transparency demands it do so in support of its inflation view, i.e., demand outstripping supply; else, it would have to revisit its assumption on potential output.

Given the uncertainties and discordance in inflation-output dynamics, a more prudent course may be to take a bit more time than three weeks to review the course of monetary policy. The most telling evidence is the banks departure from normal behaviourhistorically, they have quickly responded to tighter signals from the central bank, but are stubbornly sluggish when it signals easier policy. In this instance, nearly a quarter has passed but banks are yet to pick up tightening signals from September! The gap in banks assets and liabilities is widening, and many are lowering home loan rates to attract borrowers. These signs suggest any further monetary tightening may not even impact due to lack of transmission; rather it may test RBIs credibility. The central bank must note that it is working with a new inflation measure when the economy is into the trough and an upturn not yet a certainty. It shouldnt stake too much on just December inflation numbers.

The author is a New Delhi-based macroeconomist