Even a cursory look at the two charts in the latest Economic Survey, out recently, on inflation forecasts versus actual levels over the past three years is instructive. There are large forecast errors—in the last 14 quarters, inflation has been overestimated by 180 bps in six quarters, and we are talking of just 3-month-ahead forecasts. But RBI has been almost as wrong as professional economic forecasters, so even its critics have to admit it was not alone in doing so. You may or may not agree with chief economic advisor Arvind Subramanian’s critique of RBI, but when the errors are so large, it is important to understand why—the Survey devotes a full chapter to just this. While Subramanian gives many reasons for why there has been a paradigm shift in India’s inflation outlook, he argues that, broadly speaking, high inflation has coincided with surges in commodity prices—especially oil and food—and, in some cases, due to sharp depreciation of exchange rates. While arguing that the government’s supply management has been very good and that farm production has become less volatile or monsoon-proof, the CEA argues there seems to be, broadly, a cap of $50 per barrel for global crude prices since, at that price level, US shale becomes profitable—so, the moment oil prices cross this, US shale swings into production and brings prices down.
The fact that the global economy remains sluggish also suggests it is unlikely that commodity prices are going to reach anywhere near the levels they were at when the Chinese economy was on a tear. It is, for instance, when global food prices rose by large amounts that India has had to hike MSPs by large amounts and that, in turn, caused local CPI to spike. It is not clear how members of the Monetary Policy Committee react to Subramanian’s argument about inflation having settled into a dramatically lower trajectory for the medium term, but certainly there is less focus on the upside risks from, say, global commodity prices rising.
In even the last monetary policy statement in June, RBI said “at the current juncture, global political and financial risks materialising into imported inflation and the disbursement of allowances under the 7th central pay commission’s award are upside risks.” That, of course, is the reason why all members of the Monetary Policy Committee, with the exception of Michael Patra, voted for a cut in the repo rates to stimulate the sluggish economy—the only other dissent was from Ravindra Dholakia who, once again, argued in favour of a 50 bps cut since, in his view, the RBI forecast would once again overshoot inflation by around 50 bps. Most talked of output gaps still being large enough to exert a downward pressure on inflation, of depressed demand conditions etc.
While Patra thought there could be second-round effects of HRA on inflation—Governor Urjit Patel felt it was something to watch out for—Chetan Ghate felt the impact would be muted due to “depressed demand conditions in the real estate sector”. And while others, like Pami Dua and Viral Acharya talked of the inflationary impact from farm loan waivers, Dholakia pointed out that no state had breached FRBM limits while making waivers. The Survey, on the other hand, argues the loan waivers will be contractionary since states will spend a lot less because of the need to fund them and this will not be compensated for by an increase in consumption by those that get the waivers. While members can have different views on the future, the question that arises is how long should MPC wait for known-unknowns to materialise—it could, theoretically, wait till next March or even later to take a call on the impact of loan waivers.
Some of the justifications given by members for their recommendations is even more bizarre. Patra, for instance, argues that “the financial environment is bubbly and frothy … a perfect recipe for a financial imbalance … a rate cut can amplify it if the central bank is seen as encouraging risk-taking.” Acharya says “higher real rates are justified in the meantime as absent efficient transmission, attempts to address symptoms of balance-sheet problems with aggressive monetary easing get wasted and can even backfire by misallocating investments, fuelling asset price inflation, creating false hopes of a growth boost, and relaxing the pedal on deeper structural reforms”. While former CEA Arvind Virmani has dismissed the argument in a series of excellent tweets, the short point is that, apart from demand-side gains from lower rates, RBI is influencing the risk-free interest rate while “misallocating investments” will depend upon the risk premium attached by investors/lenders to different activities. And the counter-question: will raising interest rates
While former CEA Arvind Virmani has dismissed the argument in a series of excellent tweets, the short point is that, apart from demand-side gains from lower rates, RBI is influencing the risk-free interest rate while “misallocating investments” will depend upon the risk premium attached by investors/lenders to different activities. And the counter-question: will raising interest rates prevent misallocation, because if it does, we might as well do it.