The committees recommendation to completely overhaul the system matches Governor Raghuram Rajans perception that the old framework had outlived its utility as the institution seemed to have relapsed into a phase of self-doubt; a phase wherein it was no more convinced it could rely on WPI-headline inflation as the nominal anchor; raised questions whether the multi-indicator approach was able to adequately respond to the situation at hand; and became unsure if it had sufficient autonomy to conduct an effective monetary policy. The committees recommendations have broadly responded to these three key concerns.
Not surprisingly, RBI decided to implement two of the reports key policy suggestions in its monetary policy review on January 28, even without formally announcing acceptance of all, or part, of its recommendations. Inflationary expectations would henceforth be anchored to headline-CPI inflation with a glide path to achieve a medium term target of 4% ( 2% range). While some analysts believe that by doing so, RBI has made its intent clear, others make a case that the regime is already into a zone that could be characterised as inflation targeting light (ITL), a regime that kicks in the transition phase, to prepare ground for its full adoption at a later date.
We, however, are of the opinion that the Governor has only implemented the softer part of the recommendations of a very hard framework, which prescribes raising policy rate as much in the ruthless pursuit of its objective to bring down inflation. In fact, the report recommends that real policy rate should become significantly positive with immediate effect to make any meaningful dent to inflationary expectations. The real test, therefore, would depend on how soon the Governor is able to raise rates to a level that can deliver the required punch to knockdown CPI inflation.
The Governor has been careful so far; with three gradual hikes of 25 bps each to 8% this January, he has just about aligned the policy rate to CPI-core inflation rate. He has been extra cautious to avoid market sentiment turning hawkish by the forward guidance to not raise the policy rate any further; consistent with its medium-term glide path and the projection that headline-CPI would decline to 8%, once vegetable prices related noise settles down. At 8% though, core-CPI remains significantly lower than headline-CPI, as the accompanying graph shows.
Market analysts, however, are turning nervous about the observed stickiness of CPI-core. The question uppermost in their minds is what happens to the policy rate if a fall in headline CPI is not accompanied by any meaningful correction in its core-inflation rate. Will RBI reduce the policy rate commensurate with a full 200bps correction Many in the market have turned sceptical, suspecting RBI might seize the opportunity to align its policy rate to headline-CPI in line with the Patel committee report recommendation. If so, analysts apprehend the policy rate will remain elevated in the short to medium-term, consistent with the less elastic CPI-core and volatile food prices, denting investment and growth.
It is no ones case that only a softer interest rate regime could revive animal spirits to back-track investments, but at the same time, it is undeniable that interest costs have been mounting on firms balance sheets. Weighed down by increasing wage bills, rising land costs and project delays, manufacturing and infrastructure sectors are feeling short-changed by RBIs decision to usher in a new regime that is structural in nature. Aligning the policy rate to headline-CPI inflation would work to their disadvantage as their own revenue is inflated by a much lower rate, captured by WPI-core inflation. While concern regarding a negative deposit rate is genuine, it cannot be ignored that credit growth has been falling below deposit growth rate for past two months, pointing to the possibility that growth could indeed suffer.
RBI has been downplaying this fear, assuring that there is no trade-off between inflation and growth, at least in the present Indian context and therefore, the new framework would be a win-win option. But its worth noting that any faltering in growth outcome could rekindle precisely those elements of uncertainty that are antithetical to the very framework the central bank is keen to implement. There is no doubt that any formal adoption of the full framework in letter and spirit would be a difficult choice for a government as it would not only have to concede near-absolute autonomy to RBI in its conduct of monetary policy, but also extend support by way of strict fiscal discipline and willingness to accept primacy of inflation outcome over that of growth. An adoption of the hard framework therefore, implies extensive consultation between the two bodies, the government and the central bank.
The author is a New Delhi-based macroeconomist