While the NDA government is currently engaged in fierce debates about the veracity of GDP estimates and unemployment statistics, its achievements in significantly bringing down inflation and sustaining macroeconomic stability during its 5-year tenure are widely acknowledged. The government claims that this stellar success is mainly due to its legal backing of RBI’s inflation-targeting (IT) framework, supplemented with fiscal discipline and supply-side reforms in the food economy. The critics point out though that India was no exception—it benefited hugely from the collapse in international oil, food and commodity prices in a persisting global deflationary ecosystem. They also vigorously argue that the government’s claims on policy effectiveness could be premature or misplaced:
> The early claim to success of the IT framework remains unsubstantiated: monetary policy transmission channel remained mostly blocked—a banking system saddled with high NPA levels and legacy deposits raised at higher rates has been operationally less responsive to any rate signal in either direction. For example, SBI, the country’s largest bank, did not increase its base rate from 10% since September 2013 through January 2015, in spite of a 75 basis points hike in the repo rate to 8%. When the rate cycle reversed, banks were again slow to respond—SBI’s base rate lowered just 95 basis points by February 2019 against a cumulative 175 basis points reduction in the repo rate. Moreover, RBI’s desperation to force the marginal cost of funds based lending rate (MCLR) from April 1, 2016, on fresh loans had very little impact—SBI’s 3-year MCLR at 8.75% is currently just 30 bps lower than its base rate. That leaves the expectation channel as the key anchor, which is ridden with uncertainty. Numerous explanations are being extended: consumer expectations vs business expectations; forward looking vs backward looking; headline vs core; and food prices vs POT (potato, onion and tomato) prices—one wonders what macroeconomic diagnostic tools are applied to turn correlation into causation!
> Signals from the bond market weren’t any different either. The 10-year bench mark yield declined a mere 30 bps since May 2014 whereas headline CPI inflation collapsed by 600 basis points. Flipping the same point around, one could ask if the government has been fiscally prudent, why have G-Sec yields not corrected commensurate to such a massive decline in inflation? Following the CAG report’s revelations, it is now abundantly clear that fiscal consolidation on the budget conceals large off-budget revenue and capital expenditure—some analysts estimate the general government deficit, which includes Central government, states and PSUs, might have stayed the same as 5 years ago!
> There isn’t much on supply-side reforms in agriculture either. The biggest initiative, e-NAM, has hardly taken off. Nor was there any technology breakthrough comparable to the scale of the 1970s HYV seed-led green revolution; no trend acceleration in crop output or sectoral value addition relative to the previous 5 years under UPA-2, too.
Then what explains the current phase of disinflation? Analysts have been examining trends in two of its major components—food and core inflation. Between the two, it is the sharp decline in food inflation that has surprized everyone—food price inflation (47.25% weightage in CPI basket) has corrected over 1000 basis points since May 2014, remaining below 2% on average since September 2016, periodically sliding into deflation. But core inflation has moderated only 300-350 basis points since May 2014, remaining sticky at around 5%. This was counterintuitive: first, food inflation is mostly a domestic, supply-side problem and generally flares up during droughts (but it fell during two consecutive drought years, 2014-15 and 2015-16); secondly, external shocks mostly reflect in WPI movements, not CPI (Patel Committee report, 2014: page 13); and thirdly, monetary policy has very little influence on it.
What could have pushed down food inflation so sharply in the absence of technological breakthroughs or structural market reforms? Intuition guides that lower import parity prices could have acted as a ceiling to domestic price formation for some food items, given the government’s alacrity towards cheaper imports (pulses, onions, etc) to augment domestic supply. The government also took some orthodox market intervention measures: a 1970s-like buffer stocking of pulses and rigorous implementation of stock limits upon private traders, besides moderate MSP hikes for cereals in the initial years. Could these measures have been sufficient to push food prices into the deflationary zone without demand-side constraints?
RBI, which examined these trends in a conventional matrix of structural (supply-side improvement) and cyclical (business cycle/demand slowdown) factors, faced severe criticism for its persistent inflation forecast errors. The CSO’s latest revised GDP estimates showing trend acceleration in growth, possibly above potential, has further compounded the problem. With demand-side aspects completely knocked off and supply-side factors exhibiting little explanatory power, structural models have ended up assigning undue credit to the new IT regime!
However, the shockingly high unemployment and labour displacement from the workforce revealed by unreleased NSSO reports (Unemployment Survey and PLFS, 2017-18) contradicts this position and raises fresh questions if deflation in food prices reflects structural demand destruction. Critics have long argued that demonetisation and faulty GST implementation turned the cyclical slowdown into a structural one by depressing informal and farm sector activities. The PLFS findings largely corroborate such presumptions although there isn’t much analytical work yet to press this point further. But these unemployment statistics could certainly be correlated with the unprecedented slowdown of private investment, stretching over eight years. Many critics have said that higher real interest rates have exacerbated the condition of private firms with stressed balance sheets. From an investment perspective, the outcomes are even bleaker—RBI data shows the weighted average lending rate of commercial banks these last five years corrected only 170 bps to 10.38% in January 2019 from 12.17% in May 2014. With farmgate inflation staying closer to 2%, the real interest rate from an investment viewpoint was as high as 8%. Not surprisingly, many firms with healthy balance sheets and cash flows have stayed away from investing afresh. A recent CMIE study of 8,544 companies shows the average share of retained profits in net profits in the four years to 2017-18 was 23%; this is about 50% lower than a 47% share in the preceding four years, showing most firms preferred higher dividend payouts.
It is in this context that the MPC’s decision to further lower the policy rate by 25 bps is unlikely to alter the situation on the ground. To be able to meaningfully influence the investment dynamics, it may have to aggressively signal several rounds of rate cuts. With core inflation stuck at 5% in a two-paced economy, majority members apprehend that if food inflation rebounds then headline CPI inflation could converge toward core to overshoot the medium-term target of 4%. While food inflation could witness temporary spikes due to monsoon failure or election-related reflation, there is not a single study backing its structural reversal in the medium term. Unfortunately, RBI’s in-house research cannot rework its forecasting model using NSSO’s unemployment data because these are virtual (unofficial)! If such a model were to project an alternative scenario where core inflation converges towards the headline, the window for multiple rate cuts would certainly open up!
Looking back, it is apparent that India suffered a balance sheet recession, which is deep; misdiagnosis and consequent policy errors have delayed the recovery. With the world economy slipping into another round of recession, India risks deflation, not more inflation. Further misdiagnosis could well push private investment into deep freeze and the economy could suffer more job losses.
Author is New Delhi-based economist