India is possibly entering a phase of low inflation for the first time since 2005, aided by structural caps to price pressure in food and fuel, suggests Volume II of the Economic Survey for 2016-17, tabled in Parliament on Friday. While good farm production and resilience to erratic monsoon would help keep a lid on food prices, the rise of shale oil and gas technology has cut costs and driven up output globally, especially from North America, undermining the influence of traditional Opec suppliers.
In a veiled criticism of the Reserve Bank of India (RBI), the survey says the central bank has overestimated inflation by more than 100 basis points in six of the past 14 quarters (three in 2014 and three in the most recent period) with an average error of 180 basis points.
Not surprisingly, the benchmark interest rate of 6% (that, too, after a 25-basis-point cut this month) is above the neutral nominal rate by 25-75 basis points, the survey says. This is because real neutral interest rates, usually, hover around 1.25-1.75%. That implies neutral nominal rates of 5.25-5.75%, considering the inflation target of 4%.
The survey said both expected inflation and GDP are subdued relative to their equilibrium levels. The current retail inflation of 1.5% (in June) is running well below the 4% target and the economy is lacking the dynamism to push this back toward the target.
“Cyclical conditions, then, suggest that the policy rate should actually be below — not 50-100 basis points or so above — the neutral rate. The conclusion is inescapable that the scope for monetary easing is considerable, more than that suggested by comparison with neutral interest rates,” the survey says. Also, the earlier the easing, complemented with other reforms, especially to address the twin balance sheet problems challenge, the quicker the economy can move towards its full potential.
Even if the pass-through is inadequate, the survey argues, there are gains to financial stability from the rate cuts, as lower cost of funds without a commensurate decline in lending rates will help restore banks’ profitability. Lower rates will also help resolve the twin-balance sheet problem — over-leveraged companies and bad-loan-encumbered banks.
As such, pass-through at private banks has been more than at public-sector ones, “conferring a competitive advantage that should be encouraged”. Moreover, for all banks pass-through has been high in case of new advances (since April 1, 2016, all rupee loans are linked to marginal cost of funds-based lending rate).
The survey points out that since 1977, there have been broadly four phases: High inflation, averaging 9%, for about 23 years; low inflation of about 4% between 2000 and 2005; a resurgence of inflation back to about 9%from 2006 to 2014; and now a new phase of relatively low, possibly very low, inflation.
Since high inflation mostly coincides with surges in commodity prices, especially for oil and food, any positive structural changes in the oil market and in domestic agriculture could also effect structural shifts in inflationary process. “…there are reasons to believe that both changes are underway”, the survey says.
Rig capacity has been declining in response to lower oil prices and quickly expanding as oil prices rise. “This accordion-like quality of shale oil and gas combined with estimates that viability is achieved close to $50 per barrel means that oil prices are broadly capped,” the survey said.
Similarly, although average real growth in farm GDP has remained in the 3% range, the volatility of output growth as measured by the coefficient of variation has dropped from 1.87% in the period 1988-2004 to 0.75% since. Cereals — the major item of consumption — have become less volatile and more resilient to poor monsoons.