In it's first monetary police committee meeting for the financial year 2017-18 (FY18) in April, the Reserve Bank of India projected Consumer Price Index (CPI) inflation to average 4.5 percent in the first half of FY18, and 5 percent in the second half of the financial year. However, a lot of water seems to have flowed under the bridge since then. The inflation numbers for April presented a significant downward surprise and the gross domestic product (GDP) numbers for FY17 show that growth had been declining since June-September 2016. For a change, the growth narrative and declining inflation numbers now lend sufficient credence to the view that broader macro policy support might be the need of the hour for the economy.
There have been two surprises by the RBI in the last previous two successive policies:
- First the shift to a neutral strategy in February; and
- In April narrowing the monetary policy corridor.
Both these measures did push up the term structure of interest rates. The 10-year yield that was hovering around the 6.4 percent level did touch 6.99 in early-May, and then dropped after the April inflation data was released in mid-May.
Capital flows into India have been strong, since the change in RBI's stance. An estimated Rs 1 lakh crore ($15.6 billion) has come in, leading to a 4.5 appreciation of the Rupee since February 2017. Coupled with this, we estimate that the net deposits (deposits net of credit) as of today in the banking system, from the date of demonetisation, is still around Rs 2.7 lakh crore.
As a result, the build-up to the June 7 policy announcement seems to have undergone a change in narrative since February 4, 2017. While liquidity overhang remains the central theme for monetary management, consider these use of words by the MPC members in the last few policies. “Core inflation is sticky and there are upside risks to inflation from GST, El Nino, Pay Commission and geopolitical risks”, “Positive growth outlook” and “swift reversal of aggregate demand loss following rapid remonetisation” etc.
It now seems that such inflation fears may have been unfounded, and even the optimism of quick growth recovery seems to have been misplaced.
Why do we feel that inflation fears are now largely subsided? Let us take each of the issues mentioned by the MPC at the last meeting.
- First, is the issue of stickiness of core inflation. To be fair in making an inflation assessment, we must distinguish between core inflation stickiness and core inflation stability (average of 4.7 percent for the 24-month period ending April 2017).
- Second, in terms of food inflation, the fears of an increase in the prices of cereals, sugar, and protein-rich items (other than pulses) are unwarranted, to say the least. That holds even if one looks at the non-seasonally adjusted month-on-month increase in the prices of these items for FY17 and compare them with trend averages.
- Third, the fear of an El Nino is also unwarranted. The India Meteorological Department has predicted that this year's monsoon would be 'Normal' or around 96 percent of the Long Period Average (LPA), with an error of ± 5 percent, and with a fair distribution of rainfall across major parts of the country. The establishment phase of the monsoon north of the equator has already started, and the Indian Ocean Dipole phenomenon — this is what counters the impact of an El Nino — will have an incremental positive effect on the monsoon. Australia’s Bureau of Meteorology has also said that there concerns are easing over an El Nino.
- Fourth, fears of imported inflation have now subsided with the rupee appreciation. Analysis of oil price movement since 2011 suggests that prices have always been lower in the second half over these last 6 years, than the first half of the year.
- Fifth, the potential second round impact of the Central Pay Commission adjustment continues to form a key argument for higher inflation numbers. This is a somewhat strange argument to make at the current juncture when the implementation of higher allowances has not taken place at the central government level. Also, the statistical impact of the first round adjustment is going to be spread out.
We now expect CPI to stay below 3 percent until September 2017 — with a sub 1.5 percent reading also a possibility — before moving up.
Against this backdrop another issue to highlight is whether the central bank should rush towards reaching the 4 percent target in FY18 itself. January 2018 was the deadline that had been suggested earlier. A point of caution here.
Empirical evidence suggests that inflation-targeting countries that tend to dis-inflate rapidly in the initial years, tend to witness a decline in output.
This is commonly called a ‘sacrifice ratio’ in economic literature. In 1978, American economist Arthur Okun said “sacrifice ratio measured the average estimate of the cost of a 1 point reduction in the basic inflation rate - was 10 percent of a year’s GNP, with a range of 6 percent to 18 percent.”
Other studies also tend to confirm this. Countries with inflexible labour and product markets — a case in point could be India itself — tend to witness a larger increase in sacrifice ratio following the introduction of inflation targeting. In 1999, Palle Andersen and William Wascher estimated the sacrifice ratios for a sample of 19 countries for the Bank for International Settlements. They highlighted that as the average rate of inflation for the 19 countries fell from 8 percent to 3.3 percent, the average sacrifice ratio increased from around 1.5 to about 2.5. Although sacrifice ratios appear to have risen in virtually all countries, the increases tend to be smallest in those that have adopted measures to deregulate labour and product markets.
In 2015, an RBI Working Paper estimated the sacrifice ratios for India in post-liberalisation period as closer to 2.5.
So what could the RBI do on June 7?
While it may be difficult to move from a neutral mode so quickly, as it may create uncertainties in the market, the apex bank could flag that inflation risks are clearly balanced towards the downside; with a clear distinction of inflation forecasts over the short-term and the long-term.
The short-term inflation forecasts could be even provided in an excel spreadsheet. Additionally, long-term forecasts/fan charts could now be given by RBI only twice during the year, April and October and not in all policy statements.
In addition, a widening of the corridor or a signal on the Standing Deposit Facility would be a well thought and pragmatic move to push the yields down and ensure monetary policy transmission against the backdrop of significant liquidity overhang in the system.
Soumya Kanti Ghosh is Group Chief Economic Advisor at State Bank of India. Views are personal.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.
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