In making the decision to cut the repo rate by 25 bps, the MPC was neither dovish, nor hawkish, just pragmatic
The recent decision by the monetary policy committee (MPC) to lower the repo rate by 25 bp, to 6.25%, has been met with criticism and scepticism. Some analysts have gone as far as to assert that there has been faulty judgement. This criticism and commentary is all part of a healthy democratic system. Also fair is that some critics (like myself) find fault with the criticism of the critics, and even find it unfair. As it happens, I also think that the RBI-MPC is unnecessarily using some very faulty tools. Just to put my cards on the table, I believe that the MPC and Governor Urjit Patel have reached the best decision that was possible with the data they had. Historically, except for occasional lapses, RBI has been a data dependent institution, and it is encouraging to see that the tradition is being strongly reinforced by the MPC.
Questioning of the MPC decision has proceeded along the following lines. First, and most important, that the inflation rate is too high to warrant a rate cut. The last four y-o-y headline inflation numbers have been as follows: 5.5% (April 2016), 5.8%, 6.1% and 5.1% (August 2016). The RBI target is 5% for March 2017. So, how can the MPC cut rates now, and that too with a unanimous vote? Surely, and unlike Rajan, the MPC is giving in to political pressure (ministry of finance) and major corporates (who always want interest rates to be cut). Further, the MPC is emphasising growth over inflation, i.e., they have all turned doves.
It is likely that the unfortunate manner in which Raghuram Rajan was not reappointed is colouring perceptions and interpretations of many commentators. For, the fact remains that rather than being different than Rajan, the MPC (and Patel and RBI) are doing what Rajan would have done. How do we know that?
We know that from the second criticism by the “experts”. A popular conclusion of the experts is that RBI has softened because it has reduced the real policy rate range from 1.5-2% to 1.25%, i.e., RBI was now targeting a 1.25 percentage points gap between the repo rate and CPI inflation. This was articulated by MPC RBI member Michael Patra in the press conference following the MPC decision. So, the experts are right in stating that the real policy rate is now 1.25%.
But the experts are very wrong in deducing that this is a change in policy. Look at the following headline after the June policy meeting of the RBI under Rajan “Will have room to cut rates if inflation stays at 5%” (The Indian Express, June 9). The article goes on to quote Rajan: “If we get confident of achieving 5 per cent inflation target by March 2017 then we will get more space to cut”. What RBI, and MPC, did on October 4 was a continuation of RBI policy. There has been enough data on food-prices, especially prices of pulses (and fruits and vegetables), to suggest that the next six-month course of such prices is, at best, stable at current levels, and is likely to be lower because of the influence of good weather and increased acreage, and prospects of higher yields, for “inflation-elastic” crops like pulses.
This assessment, and forecast, has no relationship with being dovish, or looking at growth more than inflation, or giving in to the demands of industrialists and/or the ministry of finance. Indeed, if the MPC had not unanimously agreed to cut rates, they would likely have had egg (and worse) on their face next week when the CPI data for September is scheduled to be released—a figure of around 4.3% y-o-y headline inflation will not be entirely surprising. The simple point is that all of us are rightly expecting the MPC to be responsible—and when they do act responsibly, by cutting rates in the face of considerable evidence to do so, let us not besmirch their honour, or intelligence, by attributing to them false motives.
But, the MPC has room to improve. A central feature of all inflation-targeting regimes, and all bankers and all economists, is that the key to lowering inflation rates is the lowering of inflation expectations. In the case of already low inflation, the goal is to keep expectations stable. And as we now know for some developed economies (Japan, Europe) the key to successful monetary policy is to raise inflationary expectations.
In the first MPC-RBI policy statement, one finds the following statement on inflationary expectations, and how important and influential they are: “Households reacted to the recent hardening of food inflation adaptively and raised their inflation expectations in the September 2016 round of the Reserve Bank’s inflation expectations survey of households.”
Given the importance of inflationary expectations, one would think, and believe, that central bankers would strive to make sure that they measure properly such expectations. Or at least measure them to the best of their ability. It is not clear that RBI has ever fulfilled this mandate. In January 2015, at the beginning of this rate cut cycle, RBI cited the results of the most recent RBI’s inflation expectation survey (RBI-IES, December 2015), as supportive of a rate cut (25 bps, from 8% to 7.75%). This survey had shown a decline in one year forward expectations to 9.3% from 13.5% at the end of the previous quarter (September 2015). In my commentary on this rate cut (goo.gl/oGK1NH), I had this to say: “Since when was high expectation of inflation of 9% low enough to warrant a rate cut? I fully agree that interest rates should be cut—but not because a junk RBI survey shows a decline in inflation expectations to a high 9% level. Better to junk junk than to offer it as an explanation—it makes all of us look bad.”
One and a half years later, and with an MPC in place, there is no change in this one bad habit of RBI—the bad habit of using a junk survey, a junk result, to justify its otherwise very sound reasoning. Don’t take my word, or believe me—but do peruse the chart. There are two lines in the chart—actual y-o-y CPI inflation for each quarter, and the year ago forward expectation for the same quarter. For example, at the time Rajan cited the junk survey in January 2015, y-o-y inflation in 2014Q4 was 4.1%. The forecast of the junk survey for this same quarter was 13.5%!
Note also that there is no learning by doing on the part of the survey respondents. As inflation has declined, the forecast error (gap between forecast and actual) has widened, and to a near double-digit magnitude. It is intellectually embarrassing to even report these data, let alone use it.
The MPC is a new and progressive institution. The reasoning behind the vote, and the vote, of each MPC member will be made public 14 days after each meeting. We already know that it was a unanimous vote to cut. Let us hope that none of the members cite junk inflationary expectations as their reasoning.
Surjit S Bhalla, The author is contributing editor, The Financial Express, and senior India analyst, The Observatory Group, a New York based macro-policy advisory group. Twitter: @surjitbhalla