The monetary policy review that just concluded did not surprise many. Most expected the central bank to remain on hold. Neither was its guidance about conditional early easing unanticipated, given the accelerated pace of inflation decline in recent months. It is the extent of future monetary easing that is the matter of conjecture. The significance of this review lies in three aspects discussed in and outside the formal statement. The first is the central bank’s observations on weak transmission by banks; the second is its indication of government comfort with a medium-term, 4% (+/-2%) inflation target; and the third is about moving towards a single, common real interest rate in the economy. What might these developments mean for the economy?
Para 18 of the statement observes that “…the weak transmission by banks of the recent fall in money market rates into lending rates suggests monetary policy shifts will primarily have signalling effects for a while.” This puzzler seemingly turns monetary policy transmission process as normally understood on its head. The dynamics originates from the central bank’s policy rate, its influence and control over the short-term interest rate (call rate in this instance), thereafter impacting retail interest rates, viz commercial banks’ deposit and lending rates, to affect aggregate demand in the final stage for the desired effect upon the inflation rate. This is textbook description, of course; in practice, the signal may not conduct for a variety of reasons. But is it that RBI wants banks to ignore its inflation outlook embodied in its policy signal and take individual views? Or do we conclude that the overnight rate which RBI controls and has fallen below the policy rate floor from August has the central bank’s blessings? In which case, why not adjust the policy rate? And that this non-transmission is linked to signalling effects of future monetary shifts compounds the puzzle. Who signals, who follows is the question?
Next, the earlier-than-anticipated achievement of a 6% interim target, which is the upper bound of the medium-term target band, enormously helps adoption of the 4% (+/-2%) inflation target beyond January 2016. The current 249 bps gap between the policy rate (8%) and core-CPI inflation (5.51%) affords sufficient head room to RBI to ease next year as also retain policy latitude to accomplish what is required for success in inflation-targeting: This is the ability to see through temporary shocks without a monetary response. So, for example, should monsoon performance in 2015 fall short of normal with concomitant rise in food inflation, RBI will have policy space to observe or test if the disturbance self-dissipates without spillover into core inflation; this should happen if public beliefs that inflation will be kept low by a credible central bank are sufficiently entrenched so as to prevent translation of transitory price increases into a generalised one. RBI wouldn’t really have to change direction of its monetary stance. Such consideration will influence how much RBI cuts interest rates next year.
Three, the central bank is looking for convergence in producer and consumer price inflation rates so there is a single, common interest rate for the two segments. In response to a question on the real interest rate the central bank is looking at, the RBI Governor explained:
“…the reality is there are different kinds of real rates prevailing in the economy today, so when you say ‘the real rate’ it is not clear which one we should pick. For example, if you talk to a variety of producers they will say that what the inflation they are seeing both on the output as well as the input side is much lower than say the inflation the consumer is facing. And obviously from the consumers’ perspective the real rate they would like to see is the real rate they get on their financial savings which would be the nominal minus the inflation rate they experience. While from the producers side it would be similarly the kind of real interest cost that they pay which they might see as the nominal interest they pay minus the producer price inflation that they are seeing. So essentially our aim is to try and bring a more common real interest rate in the economy and the way we can do that is by, in a sense bringing inflation back on the consumer side more towards where the producer price inflation or the wholesale price inflation is, so to in a sense integrate the inflation rates across the system.”
Indeed, the producer-consumer price divergence has been our chief concern in shifting to CPI as the nominal anchor at a low point of the economic cycle (see, for example, “RBI policy hurting manufacturing” FE, November 3, 2014—https://goo.gl/MW3371). The spotlight on convergence of the two inflation rates is welcome therefore. How might this play out though? A sense of the adjustment that might be needed in CPI inflation can be got from its current distance from WPI inflation: The gap in the respective core inflation rates was 330 bps in November 2014 (core-CPI inflation 5.51% and core-WPI 2.21%). The monthly average gap from January 2012-October 2014 works out to 419 bps, indicating a historically wider band.
This isn’t static though. What will matter is also the evolving divergence ahead. Producer and consumer prices are differentially impacted by different type of shocks. While global price swings (for example, imported inputs like oil, other commodities, etc) impact wholesale price inflation more, making it vulnerable to terms of trade shocks, consumer price inflation is affected by domestic disturbances (for example, monsoon failure, food supplies, etc). Going forward, core-WPI inflation could well be even weaker given the sharp oil-commodity price corrections; these could fall further from slower global growth, particularly China which accounts for nearly half of world demand for commodities.
If the WPI inflation scenario plays out accordingly, significant CPI disinflation may be required to close the gap. This might also influence the extent to which RBI may cut policy rates in 2015. Choosing a faster pace of retail price disinflation would mean lesser extent of monetary easing, for example. At the very least, the extent of disinflation required could be in the region of 2 percentage points. One can imagine this may be incorporated in the glide path towards the mid-point of the medium-term 4% target ahead.
If so, correcting the current anomaly in costs and incentives faced by producers and consumers may imply further compression of demand. Fiscal consolidation in that case would go beyond the accepted consolidation targets for 2015-16, given the tightening of budgetary constraint from lower real GDP growth. However, in these economic conditions, further fiscal contraction is not a desirable option. A better route to narrowing the producer-consumer price gap instead is through competition-enhancing reforms in the key retail segments. This will lower transaction costs and retail margins, which have risen because of demand-supply imbalances caused by high growth of preceding years. Taking this path could relieve monetary policy from doing the job. It will also avoid further lowering the pace of demand growth. And with convergence of producer-consumer inflation rates, we could well see monetary transmission repaired.
Renu Kohli is a New Delhi-based macroeconomist