As the bimonthly review of the monetary policy approaches next week, there seemed a near consensus that the Reserve Bank of India (RBI) would hold on to the current policy rate until the next review in October; mainly to see through the impact of a faltering monsoon on food prices. However, bond market developments seemed to suggest the central bank could be preparing the ground for a turnaround in monetary policy stance! By setting the new benchmark yield at 8.4%, 43 bps lower than previous one, RBI appeared testing if the market?s long-term inflationary expectations have moderated. Will Governor Raghuram Rajan surprise everyone by cutting the policy rate on August 5?
After all, in its June review, RBI had hinted that there would be scope to cut the policy rate should inflation pressures subside faster than anticipated. Two data points since then show a steady decline in headline retail inflation, with an almost one point drop to 7.31% in the year to June. Adjusted for base effect though, both headline and core CPI inflation rates display a sequential pick-up over April to June, which would suggest the central bank is hardly rushing to ease next week.
All this and more will be a lot clearer on Tuesday. But what explains the palpable change in market views? Do real and psychological developments of recent months underlie these?
Consider the severely strained demand environment. April-June corporate results are the most recent indication?many came in below estimates; profit and revenue growth is lacklustre; costs still outpace revenues; utilisation rates across most manufacturing and infrastructure firms are the lowest in a decade; all of which hardly suggest the emergence of a new capex cycle. A key driver underlying RBI?s growth projections?implementation of cleared infrastructure projects?has seen no start; the financial stress on private firms is simply too severe, while fundamental issues remain unresolved. Banks, the economy?s mirror, show tepid loan growth, declining interest incomes and bad assets? stress, which is not restricted to only public banks. Credit off-take is the biggest give-away of how weak the demand is. Despite the recent export-industrial growth rebound, non-food credit growth remains around 13.5%, a range inconsistent with 5% growth in real GDP. In short, there are strong signs that sustained fiscal compression from October 2012, along with monetary contraction, are feeding through to aggregate demand, pulling down sticky, core-inflation pressures, but also exacerbating systemic distress.
These conditions have combined with other developments to reshape psychological beliefs on inflation. Surely, the most significant contribution comes from fiscal performance, which has overturned well-established viewpoints of markets and analysts?that deficit targets would stray beyond fixed boundaries as a pre-election spending burst would result in a breach by the previous government; that required fiscal contraction was not just sustained right until the elections, but the previous government even over-performed on the fiscal front dislodged the entrenched beliefs. The new government?s endorsement of fiscal consolidation principles further bolstered the revised beliefs about policymakers? commitment to tame inflation. Add to this the recent action on food prices, viz. a second, successive year of modest increase in agriculture support prices; supply management measures like offloading surplus food stocks, export restrictions, anti-hoarding steps; plus assurances of strong action to effectively manage food supplies ahead.
Earlier in April, RBI?s January-March household expectations survey too showed a downward shift down in the 3-month and 1-year ahead median expected inflation.
The feed-through of economic weakness and a revised inflation psychology has likely morphed into lower long-term inflation expectations. End-July, the yield curve (see chart) has slipped down remarkably?between 50-70 bps at the long end?relative to April peaks. It remains to be seen if a broader set of market participants uphold last week?s signal in the surprise multiple-price auction of the new benchmark issue announced by the central bank.
Credit market conditions too strongly indicate the current policy rate may not be sustainable for very long. This is hard for RBI to ignore. Banks, which had never fully responded to RBI?s tightening signals from September 2013?average base rates inched just 10 bps against a 75 bps policy rate increase?are faced with little demand for loans, which has compelled a downward revision in deposit rates. Early signs are that short-term deposit rates are down 10 bps on average from May. Credit demand-supply schedules seem to be trending towards a lower equilibrium overall. Do the contrary credit conditions, the lubricator of real activity, indicate that fiscal consolidation might have been incompletely factored into monetary policy formulation? That real GDP growth has systemically come out lower-than-projected for two, successive years is one hint. In this light, an important factor that could compel reappraisal of the current, overtly contractionary monetary-fiscal policy mix is how it is weighing down upon growth. If fiscal risks to inflation are contained, a relaxation of the monetary stance is reasonable in this light.
But can it be said with certainty that inflation risks have altogether disappeared? There is, of course, the near-term risk of a deficient monsoon, which could push up food inflation. Looking to long-term inflation expectations, RBI could well choose to see through a short-term, transient spike. But the sequential rise in inflation momentum is a factor. More subdued at retail levels, the pick-up in core-WPI inflation has steadily sustained for eight, successive months; quite unlike CPI-core inflation, which shows a sequential rise in the last three months. Should RBI choose to exploit headroom available from overachieving its end-year inflation target, with added confidence about fiscal performance and structural reforms that could address resurgence of inflation pressures, this is probably the right time for it to navigate out of a difficult situation. October could be quite late for altering the monetary-fiscal policy mix and contain the risks to growth.
Renu Kohli is a New Delhi-based macroeconomist