With CPI inflation at near-historic lows, according to the ‘RBI law of mean reversion’, the future means high inflation
At the February 8 Monetary Policy Committee (MPC) meeting, RBI surprised the world, and itself, by keeping the repo rate constant at 6.25%—and by changing the policy stance to neutral from accommodative. Many (all?) have criticised this decision as not grounded in economic reality; indeed, I titled my criticism as “Jaywalking at RBI” (goo.gl/YEeQVC), February 25, 2017, The Financial Express.
The economic and political events over the last month suggest that RBI was right, and the critics wrong. Through this article, I tender my apology to RBI for not seeing how right they were in their decision. Indeed, the data suggest that the time has come for the central bank and the MPC to raise the policy rate by 25 bps to 6.5%. Recall that, unexpectedly, RBI reduced the repo rate to 6.25% in October 2016, presumably much against its own instincts and under pressure from the ministry of finance. At both the post-demonetisation meetings in December and February, RBI boldly asserted its independence from the Modi government (and from the world) by not cutting the policy rate any further. It can now fulfil its independence mission by raising the policy rate back to 6.5%. The best way to do it is obviously via an inter-meeting rate hike—as the old Indian saying goes, why wait until tomorrow for what you can do today.
Here are the events, and data, that make a compelling case for RBI to raise policy rates.
First, the BJP has surprised all by winning in UP, and forming a government in four of the five states that went to the polls. This has considerably reduced political uncertainty and provides Modi a free hand to pursue populist policies. Extravagant, in-the-name-of-the-poor deficit spending is a near certainty and RBI showed extraordinary foresight in anticipating this reality at the eventful February MPC meeting. Prime minister Modi knows how exceedingly successful populist spending was for Sonia Gandhi and Manmohan Singh in the 2004-2008 period; it was this populist spending that allowed the Congress to go from 145 Lok Sabha seats in May 2004 to 206 seats in 2009.
If Modi does not do large “in the name of the poor” deficit spending a la the Congress, the government he leads will be in danger of being accused as a suit-boot ki sarkar by Rahul Gandhi and will likely lose the 2019 election. And we all know what this deficit spending can do—it will raise inflation to double-digit levels as happened in India during 2007-2013—an average of 9.4% per annum for seven years. India cannot afford that experience again. What can help put a dent in that scary prospect? An immediate rate hike by the RBI.
Second reason for raising the repo rate—high inflation being signalled by the Wholesale Price Index (WPI). Recall that prior to the change brought about by former RBI Governor Raghuram Rajan in 2013, India had used the WPI as its primary indicator of inflation. All of the serious RBI research over the last 60-odd years has been based on the WPI, and rumour has it that Rajan brought about the change to the CPI over serious objections from the RBI staff. The staff had made a career out of examining the important minutiae contained in the WPI innards. And Rajan snatched the WPI toy from RBI staffers. How would your 10-year-old feel if his action figures were taken away, without reason, and was told to go read Harry Potter?
The WPI for February 2017 has come in at 6.6%, the highest in the last 41 months! Just the previous month, the WPI inflation was 5.3%. An acceleration from 5.3% to 6.6 % in the RBI-staff-preferred indicator and, that too, in just one month! What more evidence is needed to prove the RBI assessment right about impending, and galloping, future inflation?
Third, notice how wrong the CPI is as an indicator of inflation. While the WPI has been exponential in its rise, the CPI has been exponential in its decline—CPI inflation has averaged less than 4% for each of the last four months and is likely to do the same for March 2017. Only as recently as December 7, 2016, RBI, anticipating Modi’s victory in UP and near double-digit WPI inflation, had stated in its policy statement that CPI “headline inflation is projected at 5 per cent in Q4 of 2016-17 with risks tilted to the upside”.
It is very unlikely that the January-March 2017 CPI inflation will be much different than 3.5%, almost 150 basis points below the RBI forecast of 5%-plus made just two months ago. However, this low inflation reality is not necessarily indicative of RBI being grotesquely wrong in its very short, three-month inflation forecast. For, as the inflation experts at RBI will no doubt educate us, CPI inflation follows WPI inflation with long and variable lags, and so CPI inflation will traverse above 5% very soon. And it is the future RBI expectations on which RBI policy is based.
Also, adding to the prospects of higher inflation in the future is the fact that true core inflation (CPI-inflation minus food minus fuel and minus petrol) has come in at 4.22 % in February, the lowest level since the 3.7% registered in June 2008, some 103 months ago. In the February MPC meeting, RBI had emphasised as to how sticky core inflation had been. Core inflation has been anything but sticky, more like a steep slide.
Also, aiding the RBI assessment of inflation in India is the value of the Indian rupee—at 65.3 per dollar, this is the strongest level since October 2015. Whatever goes up must come down is the best forecast one can make about the rupee—and the reverse for core inflation. Central Banking 101: Bet on mean reversion! The MPC has to act according to its perception of the future; very likely, RBI is viewing this strength in the rupee, and trend decline in core inflation, as something that has run its course and should soon be reversing.
In addition, the US Fed has just raised rates by 25bps and warned that they might raise the funds rate by another 50bps over the course of the year. Isn’t it a “historical fact” that if US short-term rates go up, Indian rates must go up by at least the same amount? Else, we will have capital fleeing the country, as Indians find it worthy to invest in 2% yields in the US rather than the 7.5% yields obtained in India.
A “rate hike in time is just fine” is a wise RBI saying. No matter what set of data one examines—political uncertainty, populist spending, WPI inflation, CPI inflation, CPI true core inflation, or US fed funds rate—all data point to the urgent need for RBI to raise the repo rate by a minimum of 25 bps with immediate effect. India is fortunate to have an MPC that truly looks ahead, correctly anticipates the future, and always acts in the best interests of the economy, and the nation.
The author is contributing editor, The Financial Express, and senior
India analyst at Observatory Group, a New York-based macro policy advisory group. Views are personal