Wednesday’s monetary policy review, expectedly, saw RBI staying put with the policy repo rate at 6%. It marks a pause in a slide that started in 2015, when it was 8%. It mirrors the sobering of inflation from its heady heights of 10% levels in 2013-14 to levels close to 4% now.
Many a times, people’s expectations from RBI pendulate between extremes.
At one end, there is a dangerous tendency to think that RBI is somehow obliged to keep boosting growth, and that low interest rates can be magically pulled out from the hat, just like GoI introduces sops in Budgets.
On the other side of whacky is the expectation that a couple of consecutive months of price rise are enough to convince RBI to start tightening policy rates.
RBI’s mandate is to ‘target inflation’, although by ‘flexibly’ accounting for output fluctuations, that is Flexible Inflation Targeting. It is accountable for the consumer price inflation to be maintained at broadly 4% (with a tolerance level of 2% either ways).
What this means is that RBI sets rates in reaction to deviation of inflation from its target rate, and changes in the ‘output gap’ — that is, the extent to which the economy is performing above or below ‘potential output’.
RBI’s policy rate should theoretically influence longer-term interest rates, asset prices and the exchange rate. These should affect bank credit and aggregate demand, which, in turn, returns to impact output gap.
Increasingly, positive output gap — growth rate exceeding the potential rate — contributes to risk of economic overheating, making goods and services expensive.
However, ‘potential growth’ is a vexingly hypothetical concept for emerging markets. A 2016 RBI working paper by Barendra Bhoi and Harendra Behera, ‘India’s Potential Output Revisited’ (goo.gl/S3irzS), estimates it to have fallen to 7% from 8% in 2003-08. Prima facie, this would suggest that the recent uptick of Q2 2017-18 GDP growth rate from 5.7% to 6.4% implies narrowing of the negative output gap, and hence reason for the RBI to stop reducing rates any further.
But on the flip side, one can also argue that the spate of reforms — the goods and services tax (GST), the Insolvency and Bankruptcy Code, bank recapitalisation, demonetisation — may have increased potential growth.
So, the negative output gap has actually widened, despite actual growth rate inching up. This would suggest aprescription to reduce the policy rate further, an opinion solely chimed in the past by Monetary Policy Committee (MPC) member Ravindra Dholakia, without seemingly any takers around the table.
The other fly in the ointment is monetary policy transmission: the effectiveness of interest-rate decisions to meaningfully affect level of demandin the economy. RBI deputy governors often bemoan how banks, incapacitated with bad balance sheets, are often reluctant to translate lower policy rates to increased lending, hence blunting monetary policy impact. To that extent, the recent expedition of insolvency cases and bank recapitalisation will hopefully lend some teeth to interest-rate transmission.
RBI’s credibility in controlling inflation — and high inflation in itself — of household items leads to increase in inflationary expectations of the public. This can get dangerously selffulfilling.
RBI’s worst nightmare would be an encore of its 2013 crisis when a deadly cocktail of high growth, increased minimum support prices, elevated commodity prices and escalating wages left the central bank playing catch up with interest rates. Eventually, inflationary expectations unhinged, inflation became generalised and RBI had to aggressively keep hiking policy rates in hope that they eventually work.
Maybe it is this fear that comes across plainly in RBI’s language in the latest policy review. Forehead creases emerged from inching up of food and fuel inflation, elevated global crude oil prices and rising input costs.
Increasingly untenable fiscal arithmetic, compounded by largesse in the form of farm loan waivers and partial rollback of indirect taxes on petroleum products, suggest that it has to account for unwelcome fiscal slippage.
Add to this, the withdrawal of cheap money by central banks of developed countries and hardening of global interest rates makes next year an uncertain one for emerging markets like ours. Very importantly for inflation targeting, inflationary expectations have been rising, which is a hard beast to control if let free.
All this has prompted RBI to eschew any policy acrobatics and play safe by holding interest rate constant.
Which is why the monetary policy statement could well have been signed off with the Beatles lyric, ‘Whisper words of wisdom/ Let it be.’