The minutes of the monetary policy committee (MPC) meeting held on February 7-8 reveal that most members turned hawkish at a time when headline CPI inflation, the nominal anchor, was falling and inflationary expectations drifting downwards. The policy statement itself, released on February 8, stunned everyone by shifting the stance from accommodation to neutral, leaving the market groping for reason. The striking thing is the six-member MPC’s view was unanimous that the fall in headline-CPI to below 4% was transitory and upside risks were distinctly visible ahead. And yet, none in the market saw this coming!
The bond market was riled as the bench-mark yield shot up more than 40 basis points, jolting expectations of any more reductions in lending rates as the demonetisation dividend came to a sudden halt. Commercial banks were visibly upset as the reversal in yield dashed hopes of sustained treasury gains, which could have helped repair their balance sheets. To the contrary, the fallout could be an increase in risk premium reflected in higher weighted average lending rates for margin protection, while the credit market could further retreat into slumber.
Six wise men versus the rest
In his post-policy media interactions, Governor Urjit Patel was forthright in emphasising the unanimity of MPC’s view that a change in stance was necessary for sufficient flexibility to respond to a few identified risks that could materialise in the short-run, viz. (a) rising international prices for fuel, metals and food alongside potential financial market volatility; (b) sticky non-food, non-fuel core-CPI at about 5%; and (c) possible reversal in food prices with receding impact of demonetisation. An advance positioning was necessary, it was reasoned, to minimise collateral costs while mounting a calibrated approach to achieve 4% inflation target within the notified band.
But the market was not oblivious to these specified risks. Yet, most expected a rate cut. It is interesting to speculate why majority of participants were dovish in their inflation outlook, while the central bank pressed the panic button. Clearly, either they did not see these risks materialising in the short-run or were unsure about the channels through which these might transmit. The MPC articulated its hawkish stance as raising the bar to achieve its inflation mandate and earn credibility in early days of its formation. A resolve therefore, to prepare for a durable reduction in medium-term inflation should have been reassuring to the market, yet it was spooked! Why? Was the communication ineffective? Or is it because the underlying explanations were unconvincing?
A neutral stance, it was reasoned, meant the MPC did not foresee much upside risks to its one-year ahead inflation forecast of 5% at the current policy rate. Policy action, therefore, could move either way depending on the evolving inflation path. But the market isn’t buying this bi-directional communication either. There is near-consensus the easing cycle has ended. While many believe there could be a prolonged pause, some are increasingly convinced the cycle could reverse much sooner. The firming of yields suggests the latter view dominates the bond market. How to interpret the formation of this unidirectional view? Does it mean the market lacks confidence in RBI’s ability to contain inflation within the 5% forecast? Or, simply rattled by the surprise, anathema to stabilising expectations—a key objective of FIT framework?
Headline to core inflation
A more pertinent question is if the MPC could’ve waited a few months to see how food inflation evolves or until core-core CPI inflation (excluding food and transportation) breached the 5% mark? Alternatively, what were the channels through which any reversal in food inflation transmits to core inflation? One must underscore that before introduction of the FIT framework, the dynamics of headline-CPI inflation was explained as a sustained rise in food inflation transmitting to core-inflation via wage hikes as the second-round effect. But food inflation has been in trend decline and wage increases are subdued for past several quarters. In such a setting, even if food inflation were to mean-revert, it was highly unlikely to spillover to core inflation. To the contrary, headline inflation below core-inflation could have a virtuous effect of pulling down core towards headline inflation and not vice-versa.
So, was the MPC fretting about the adverse turn in external commodities and financial markets and potential pass-through to domestic core inflation? In particular, was rising global oil prices the real cause for concern? But domestic fuel price inflation is largely tax-driven, which can, to an extent, be absorbed by lowering duties, minding budget constraints. Why should the MPC have first-guessed government action? Similarly, risks from higher metal prices would be insignificant, given subdued inflation of manufacturing-WPI and its limited transmission to CPI-core inflation (through small items with small weights). Prospects of transmission through the exchange rate channel in the short-run could have been contained too, given projections of a lower current account deficit.
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Falling growth potential, the hidden trigger
Why then this overt concern about sticky-5% core inflation? The only rational explanation to be found is of a falling growth potential and risks of the output gap moving closer to zero or even turning positive. That potential growth could decline with a slowing investment rate in recent years, as also some loss in efficiency, is quite likely. It is unknown if supply-chain disruptions from demonetisation would’ve lowered this further. But implications could be a build-up of inflationary pressures as lower inflation and more transmission through bank lending rate channel spurs consumption demand. While manufacturing has substantial slack at this point, capacity constraints in services are goading inflation pressures captured in CPI-core.
The monetary policy statements invariably do not talk about India’s potential growth and output gap, a key variable in FIT framework. But references did crop up in the past during post-policy interactions, e.g., April 7, 2015 when RBI assessed India’s potential growth rate at 8-8.5% under the new GDP series. These estimates however are clouded by concerns about use of inappropriate deflator resulting in overestimated real growth. In-house RBI research cited in monetary policy report, April 2016, placed potential growth at 7%. But if we were to anecdotally believe this would have fallen below 8%—closer to 7.5% or even lower—we are then fast approaching an inflexion point where the output gap could turn positive, even while gross investment continued to decelerate.
Growth given short shrift
It is amply clear that terms of trade will no longer support growth. This is distinct in the sharp, visible deceleration in government expenditure growth of 6.6% in 2017-18 with a drop in share of GDP (12.7% against 13.4% last year). Government capex will grow at the same pace this year (10.7% against last year’s 10.6%) and cannot be expected to support growth much. Private consumption decelerated in 2016-17, despite support from terms of trade gains and lower inflation.
Accommodative monetary policy could have extended support to domestic demand. Instead, both fiscal and monetary policies are now geared towards stabilisation. The premature turn in monetary stance and possibly, the rate cycle, could also render more difficult the repair of corporates-banks’ balance sheets. Left to ride on structural reforms, it is anyone’s guess how growth will sustain. Revival of private investment would have to wait until…
The author is a New Delhi based economist