It will probably be an understatement that the complexity of monetary policy has increased substantially in a challenging macroeconomic environment. After a prolonged period of monetary tightening, RBI signalled a change in policy stance in late 2011 and followed it through with CRR cuts and a 50bps cut in the repo rate in April. However, the forward-looking guidance in the April policy statement had a hawkish bias, indicating less scope for further monetary easing. Upside risks to inflation remained the focal point while growth worries were cursorily mentioned.
To be specific, RBI made three observations or assumptions about growth in the April policy statement. One, economic activity was appearing to be stronger in Q4-FY12 compared to Q3. Two, economic growth was modestly below trend. And lastly, the growth forecast for FY13 was pegged at 7.3%.
The Q4-FY12 GDP growth print at 5.3% has dealt a blow to all the above observations. It was not only worse than Q3 but the lowest in nine years. If we think that potential growth is between 7-7.5% (the RBI Governor has also mentioned numbers in a similar range), then growth was not modestly but alarmingly below trend. Also, it looks inevitable that RBI will have to substantially revise its FY13 growth forecasts downward. The official revision is likely after more clarity emerges on the progress of the monsoon. The Q4 growth disappointment, therefore, cries for further monetary easing as RBI reassesses its growth outlook.
However, three key considerations will remain in RBI?s mind while analysing the growth data. First, is the slowdown as severe as the 5.3% GDP growth and abysmally low industrial growth numbers would suggest? Growth in industrial credit has been close to 20%, PMI data has been consistently in the expansionary mode and corporate performance has not fallen off the cliff, although gross corporate tax collections have turned negative for April and May. Also, GDP growth for the same period last year (Q4-FY11) was revised up to 9.2% from an initially estimated 7.8%. Given the conflicting data points and the history of significant growth revisions, we will not be surprised if RBI is cautious about taking the GDP growth number at face value.
Second, can there be a possible rethink on the potential GDP growth number? It is true that estimating potential GDP growth is fraught with risk for an economy where basic economic relationships are extremely dynamic and there is paucity of relevant data. However, for policymaking purposes one needs to make a judgement call on potential growth. In our view, it is important to stick to that assessment of potential growth for a relatively longer term period and not make frequent adjustments based on incoming data or change in sentiment. If 7-7.5% potential GDP growth was feasible 3 months ago, then output gap today should be calculated on the basis of that estimate and monetary policy needs to be calibrated accordingly.
Third, can easing of monetary policy spur growth at all when there are other binding supply-side constraints? Unfortunately, this question does not have an easy answer. While there could be sectors where severe bottlenecks could completely negate the impact of easy credit conditions, it is also possible to imagine scenarios where lower interest rates boost sentiment and kick-start economic activity.
Even if we build a compelling case for monetary easing to bring growth back to potential and believe that interest rates do impact growth symmetrically (after all it is commonly argued that part of the slowdown is because of higher interest rates), we still have to examine whether inflationary conditions permit such easing.
Theoretically, core inflation should be the preferred metric for the central bank to judge demand-side price pressures. Core inflation declining is good news and this process should continue if growth remains considerably below the potential.
However, it is never easy to justify monetary easing when headline inflation is inching up and consumer price inflation is in double digits. Persistently elevated inflation prints may be permanently shifting inflationary expectations higher and eroding the credibility of the central bank. It is also uncertain when suppressed inflation in the form of regulated fuel and fertiliser prices will come to the fore. Global commodity prices had a sizeable correction but rupee depreciation has negated part of the favourable impact on inflation. In our view, therefore, inflation will continue to figure prominently in RBI?s rhetoric. In fact, after the release of the latest WPI number, the RBI Governor has reiterated his stance that some growth will have to be sacrificed to control inflation.
However, accepting growth slowdown as a fait accompli can trigger its own set of chain reactions. Slower growth not only worsens macro vulnerabilities like the fiscal deficit and the funding of the current account deficit through capital inflows, but also further depresses the business sentiment and reinforces the downward spiral. We think that compared to April, the June monetary policy statement should shift its bias more towards growth to arrive at the right balance.
A 25bps cut in the repo rate would signal that intent without being oblivious to inflation risks. In the past monetary easing has started with liquidity easing and making the overnight rate drop from the repo rate to the reverse repo rate. However, under the present monetary policy operating procedure, that seems unlikely. So, a token 25bps CRR cut can be used to boost sentiment but its impact on overnight rates could be marginal. Delay in monetary transmission is common in the early phase of the easing cycle and transmission could be deferred further if liquidity remains tight. We need to be patient for both slower growth to bring down core inflation and lower policy rates to trigger a cut in lending rates, supporting growth.
The author is head of regional research, South Asia, Standard Chartered Bank