Red flags in monetary policy resolution

We have a rate cut after a gap of about 18 months. The Monetary Policy Committee (MPC) announced on Friday that the policy repo rate, which goes on to influence the rate at which banks lend to customers, stands cut to 6.25 per cent, down from 6.5 per cent.  This change came along with a change in the policy stance from “calibrated tightening” to “neutral”. Most of the market participants did not expect a rate cut at this juncture but they did expect the change in policy stance.

The cut comes in the very first policy announcement after Shaktikanta Das took over as the RBI Governor. It is the last policy of this fiscal year.

The MPC has given its reasons for the repo rate cut. Among these are the lowest actual CPI inflation rates of 2.2 per cent, which is the lowest in the last 18 months. Some 30 per cent of the foods group (viz; vegetables, sugar, pulses, eggs and fruits) are in deflation, or the negative zone in inflation rates. Core inflation (headline inflation minus food and fuel) is down to 5.6 per cent (December 2018) from 6.2 per cent (October 2018). Household inflation expectation has softened by 80 basis points and 130 basis points in a three-month horizon and 12- month horizon in the December survey, over the previous round. A moderation in rural wages and the assumption of a normal monsoon add to this list.

As the RBI Governor put it: “The path of inflation has moved downwards significantly, and over the period of the next one year, headline inflation is expected to remain contained below or at the target of 4 per cent. This has opened up space for policy action…The favourable macroeconomic configuration that is evolving underscores the need to act now when it is most opportune.”

The approach marks a sudden change in favour of a rate cut even though the underlying scenario remains broadly the same as seen during the time of the December resolution. The sea change in approach can be seen on several counts.

True, we have a benign inflation outlook, but the outlook was equally benign in December 2018. Survey results by the RBI now indicate a sudden softening of the 12-month horizon of household inflation expectations, which were at an elevated level earlier. There is a lack of recognition of the elevated level of core inflation, which truly reflects the persistence of inflation. The MPC’s mandate is to look at headline inflation but in doing so, it cannot ignore important components of it, like core inflation.

Further, the MPC has recognised but not acted on uncertainty in the fuel price and upward risks of the reversal in food inflation. There is a mellowing down on how they view fiscal slippages and there is renewed optimism on the monetary policy transmission.

Under the inflation-targeting framework, the MPC is charged with keeping inflation at 4 per cent with an upward or downward band of two percentage points. One crucial factor of the policy framework is the inflation forecast as the intermediate target.  Therefore, the credibility of monetary policy action critically hinges on the accuracy of the forecast and the inflation numbers projected in the forecast.

The continued deceleration of the headline inflation was on account of a substantial reduction in food and fuel inflation. There are uncertainties on the fuel front, as far as the price of crude is concerned. Similarly, there could be a reversal of deflation in the prices of the food items such as vegetables, sugar, pulses, eggs, and fruits. Survey data on inflation expectations, particularly for 12 months ahead, need to be seen in the context of the earlier survey.

The Governor mentioned that regional offices participated to make the survey broad-based this time. The big question that remains is how in a short period of two months the survey results could take such a ‘U’ turn.

Even though the MPC mandate is on headline inflation, the elevated level of core inflation is a matter of concern and needs to be addressed. A complete denial of this development is detrimental to the overall credibility of the monetary policy.

Fiscal slippage has been a routine feature in the Union Budget. It has been a convention with the RBI and MPC to recognise the fiscal slippage explicitly but in this MPC resolution, the fiscal slippage has been assumed as a non-disruptive element. This is a disturbing development.

It is important to mention that the economic cycle in a very short run period of two months has not changed in so dramatic a manner that the monetary policy stance could be changed from calibrated tightening to neutral, with a rate cut.

Transmission of the monetary policy has been a serious concern for the RBI. The earlier RBI Governors are on record saying that the policy repo rate cut has often not translated to a cut in bank lending rates, thereby making the monetary policy redundant.  

The MPC resolution says that, “output gap has opened up modestly as actual output has inched lower than potential”. In the earlier resolution, the MPC took a view that the output gap is closing. In this resolution, without changing the growth outlook and keeping it the same, at 7.4 per cent for 2019-20, the statement that actual output is lower than the potential is not convincing.

There is a popular saying: “Torture the data, and data will yield.”  This is a trap and one wonders whether the MPC has fallen into the trap by announcing a repo rate cut.

(Pattnaik is a former Central banker and a faculty member at SPJIMR)