1. RBI: A cut in time saves nine

RBI: A cut in time saves nine

Delay in cutting interest rates would imply that the RBI is looking to bet on a horse after it has won the race.

By: | Published: November 7, 2014 2:14 AM

The camp is clearly divided. There are the “bad” industrialists, the ones who always say that the Union Budget deserves 8 +/10, are saying the time has come for RBI to relax its ultra-tight monetary policy, prevailing for most of the last few years, and especially since September 2013, when Raghuram Rajan assumed control. There are also the recent converts to a rate cut—the Technical Advisory Committee (TAC) to the RBI members voted 4-3 to cut rates at its September meeting.

In the other corner are the “good” guys, comprising—apart from Rajan and his deputy, Urjit Patel—the prestigious IMF economists, and the policy economists at the major investment houses (both domestic and international) and rating agencies like CRISIL. Their view is that the clamour for a rate cut now is bordering on nonsense. This is what one representative of this distinguished club (CRISIL) stated on November 2.

Click here for graph

“The chorus on an interest rate cut to revive the economy has got louder with the recent climb-down in inflation. To be sure, the monetary policy tool of cutting the interest rate is conventionally used to energise a flagging economy. ..But this does not hold true under all circumstances. Our study shows that factors behind the recent slowdown in economic growth and investment in India have little to do with high interest rates … leaning on monetary policy to revive investments will yield little benefit. And, it carries the risk of reversing the recent gains in inflation, which, in any case, is nothing much to write home about” (emphasis added).

In a November 4 editorial, the newspaper Mint confidently stated that declining CPI inflation was due to a tight monetary policy, and equally confidently, forecast the future path of inflation: “[The RBI should] stay on course for at least a couple of more quarters, rather than act in a hurry … tightening of policy since Rajan took charge is one important reason why inflation has begun to decline in India … It is not yet clear whether the recent sharp decline in inflation is sustainable or a temporary base effect.. Yet, this base effect is expected to wear off in the first 3 months of 2015.. It is only after April 2014 that we can get a clear picture about inflation.”

So, who is right and, therefore, what should RBI do? It should go by the evidence—and the evidence is that from the demand (output) side, the economy is hurting, and hurting bad. In normal circumstances, this large negative gap alone would justify a series of large rate cuts.

But India, at least until recently, was not a normal economy, especially with low growth and high inflation. This strange combination should have given a clue to experts that it wasn’t monetary policy that was causing the high inflation; rather a cost-push supply-side inflation over which the monetary authorities had precious little control.

The question is whether India is fast approaching normality with respect to inflation. Consider the following facts. CPI inflation of 6.5 % (new 2010 series) was the lowest rate ever in September 2014, i.e., the lowest for the last 45 months. A weighted average of the two old series—rural CPI(AL) and urban CPI(IW)—yields a national CPI series which was the lowest since the 6.0% inflation observed in February 2008, i.e., the lowest in 78 months. WPI inflation, of 2.7%, is the lowest since the 4.7% level of September 2009, the lowest in 60 months. The government-administered minimum support price (MSP) inflation, at 2.7 % in 2014, is the fifth-lowest in 39 years, and the lowest since the 2.4% level observed in 2005—the lowest in 108 months.

But this is not even considered admissible evidence for a rate cut by our base-effect vigilantes. Something that has baffled me in reading the various expert reports for the last several years is the constant allusion to “base-effects”—and intrigued me because of the dangerous, and disingenuous, interpretation of the base-effect reality. If an inflation estimate comes in below the “expert” view, the refrain is: “This is due to the base-effect” and soon inflation will rise again. If inflation comes in high as per the expert prediction, the base-effect is not invoked, and instead we get: “We told you so”.

What is this base-effect and how does one measure it? Assume for a moment that September 2013 yoy inflation was higher than normal. Then, one should expect, ceteris paribus, that September 2014 inflation will be lower than normal. But this begs the question—what is “normal” inflation in any given month? One reasonable approximation for normal inflation for any month is a three-year average. For example, average September CPI inflation for the previous three years (2010, 2011 and 2012) was 9.7%, and this is the expected normal inflation estimate for September 2013. Actual September 2013 inflation: 9.4%, which is 0.3% below normal. Hence, the base-effect for September 2014 is plus 0.3%, i.e., expected inflation in September 2014 is the previous three-year average of 9.7% plus 0.3%, or 10%.

This forecasting game (no economics, no modelling, no nothing) yielded brilliant results during the steady near 10% inflation between January 2011 and June 2013; an average forecast error of only 0.1%(!) with the worst and best forecasts of minus 1.4% and 1.1%, respectively. However, the simplistic base-effect model has completely broken down since June 2013 with average forecast errors of minus 1.0% (July to Dec. 2013) and minus 3.1% January-September 2014!

This explains both the confidence of the base-effect calculators (and this includes RBI and the IMF) till some 15 months ago, and their complete lack of credibility today. Which means that RBI has now lost both its legs for supporting a tight monetary policy—base-effect, and anchoring of inflationary expectations. Regarding the latter, the junk RBI expectations survey (when will they stop?) in March 2014 reported a three month expectation of 12.9 % inflation. Actual September 2014 inflation was almost half, at 6.5% (and was 7.4 % for the June-September quarter). And expectation of three month inflation in September 2014 is an even more junk estimate of 14.6%! Let me restate the finding: actual inflation in September 2014 is 6.5%, RBI’s anchoring inflation expectations survey claims more than a doubling of inflation in the next three months! Somebody is smoking something—please pass the weed.

It is time the base-effect and other inflation hawks admitted to a few realities and moved on. One of the most important lessons the financial markets teach you is humility—and the fact that very smart people, and very dumb people, and everyone in between, make mistakes every day. So what is the harm in RBI, and the IMF, and investment bank experts, and three members of the TAC admitting they were wrong and asking, nay pleading, for an aggressive interest rate cut policy?

If they don’t do so, my guess is that history will judge them harshly. Expertise and/or wisdom is not revealed by betting on a horse after it has won the race.

The author is chairman, Oxus Investments and a senior advisor to Zyfin, a leading financial information company. Twitter: @surjitbhalla

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