Growth concerns are back in the headlines from an unexpected quarter. Two very vocal members of the monetary policy committee (MPC) have expressed deep worries about risks to the economic recovery after their views were made public in the minutes of the MPC meetings held during September 28-30, 2022. Jayanth Varma was forthright in arguing for a pause, warning it would be dangerous to raise the policy rate above 6% when the growth outlook is very fragile; while Ashima Goyal argued that raising policy rate too fast risked over-reaction which could be very costly. Their assertions that the policy rate has reached its terminal rate are a clear attempt to alter the current MPC views, articulated publicly by RBI Governor back in April 8, 2022, viz., to prioritise inflation control over growth.
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The timing also appeared more interesting. CPI inflation has persisted above 6%, the upper tolerance level, for last three quarters, needing RBI to write to the government as per the law. It seemed as if they were asking the governor and chairman of the MPC to send a very comforting report to the government—“Please be assured that no more rate hikes are required as monetary policy acts with a lag; the 255 bps hike in effective policy rate so far should be enough to moderate inflation, albeit gradually.” It is needless to emphasise that the internal views of RBI are completely the opposite as the Governor and the deputy governor remained deeply concerned about inflation expectations getting unanchored. Should they change their views and agree to pause at the December meeting?
One could argue this would be a bit premature, especially when the fight against inflation world over is still unravelling. Policy-making has increasingly become data dependent; central banks have been wary about any forward guidance as inflation forecast errors have persevered. The operational framework of inflation targeting regimes across countries appears to be shaky since inflation forecasts have become error prone while expectation surveys have become less reliable. In fact, what one should be overemphasising is that conventional understanding and models have ceased to work in the current inflation episode driven by multiple shocks. For example, many criticise the US Federal Reserve for delayed action. However, The Economist recently pointed out that several central banks which started tightening a year ahead of the Fed, such as Brazil, Hungary, New Zealand, Norway, South Korea, Peru and Poland (termed “Hikelandia”), continue their inflation-control struggle. Thus, overtightening also has not worked.
Then what provides confidence to the two members that the MPC has done enough? They focused on three critical points: one, a repo rate at 6% could be equal to, or even higher than the estimated neutral rate that is sufficient for moderating demand to a desirable level; two, monetary policy works with a lag and one should wait until its peak effect is released; and three, RBI has sufficient policy independence not to react to decisions taken by the US Federal Reserve or any movement in the exchange rate.
All three propositions carry abundant risk in the current milieu. As underlined, inflation forecast errors have abounded across central banks and RBI is no exception. And to be sure the real rate in 3-4 quarters ahead will be positive and above the neutral rate is fraught with risks. As Michael Patra rightly notes, “The parameters that characterise recent developments are far outside the ranges predicted by the conventional models. No one really knows what is too far or what is far enough in this environment.”
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In fact, the Federal Reserve’s troubling experiences have many lessons to flag. Back in August 27, 2021, at Jackson Hole for example, chairman Jerome Powell had extended similar reasoning—that monetary policy works with a lag of one year or more, and an ill-timed policy move unnecessarily slows hiring and other economic activity. No longer does he say so however, for the lags might have become longer or even unpredictable. Similarly, in the initial months, the Fed was guided by consumer inflation expectations surveys that to date, remain well anchored. Yet, inflation has increasingly got entrenched, forcing Powell to warn about not relapsing into complacency at Jackson Hole on August 26 this year.
If inflation expectations are firming up in India where is the scope to pause? More forcefully, can RBI delink itself from external developments, especially in the US?
Markets are now expecting another 75 bps hike by the Federal Reserve at the forthcoming November meeting; and benchmark US yields are getting adjusted to a much higher terminal rate than communicated at the September 21 meeting. Can the MPC simply blink its eyes and stay neutral? The power of the $600 billion plus forex reserves has weakened quite a bit in the last quarter and the current pace of trade imbalance is simply not sustainable to finance. RBI may have to let the rupee float a little more to compress import, if not push export, of which the MPC must take note. In addition, one must flag another critical fact of Indian agriculture’s increasing exposure to adverse weather events and changing climate, coincident with depleted buffer food stocks to multiyear lows.
However, we can ignore all these risks and prioritise growth concerns, if and only if there are indicators to believe that the underlying demand conditions are very weak and the recent recovery were mere cyclical blips. Concern about export slowdown is genuine—one would presume RBI’s revised growth projections on September 2022 already incorporated these (7% in FY23 and 6.5% in FY24). Are there new apprehensions originating from domestic sources to be taken note of? For example, net profit for the early bird, non-financial corporations in the second quarter have turned negative, i.e., contraction. Is that an early indication of weak demand? Time will confirm as more results are published.
On the other hand, if India’s economy is truly a global bright spot with a firm-footed recovery, the case for a pause could be hazardous. In that case, it is RBI’s responsibility to moderate demand to better align with supply, and it cannot shy away from that. In the current milieu, that would require eternal vigilance and prompt, decisive action even if it leads to some overtightening. But if indeed the underlying demand conditions are fading, then be transparent, revise growth projections accordingly, and take a pause!
The writer is a New Delhi-based macroeconomist