Look beyond a status quo August policy

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The Reserve Bank of India (RBI) August policy meeting has lost some sheen because it appears that the introduction of the Monetary Policy Committee (MPC) has been deferred further. Still, by the virtue of being governor Raghuram G. Rajan’s last monetary policy meeting, it is likely to be a momentous one, regardless of the outcome.

Before we move on to the possible August policy outcome, let us pause for a moment and look back at the three years of governor Rajan in comparison to the five years before that: Average inflation, (as measured by the consumer price index for industrial workers, or CPI-IW), has declined to 6.6% from 10.4%. The rupee has depreciated 2-3% versus the dollar compared to 47% depreciation in the earlier period. In real effective exchange rate (REER) terms, the rupee has appreciated close to 10% and the realized volatility has roughly been halved over this period. REER is a measure of the weighted average of a country’s currency against an inflation-adjusted and trade-weighted basket of its trading partners. Policy rates have been lowered by 75 basis points (from September 2013 till now) while 10-year yields have come down by close to 160 basis points. One basis point is one-hundredth of a percentage point.

These are clearly signs of macro stability brought in by prudent policymaking, albeit aided by extremely soft global commodity prices.

It is likely that governor Rajan is going to stress this macro stability even in the August policy meet, preferring to continue his accommodative stance while keeping rates unchanged. Consumer price inflation (CPI) is hovering close to the upper end of the RBI’s target range; in the near term there is a possibility that it can even breach the 6% mark. While this warrants a cautious stance now, we are not overly worried about inflation. CPI excluding pulses, vegetables and sugar (90% of the index) is growing at only 4.3% indicating that inflation is not generalized. Also, looking beyond the near-term spike in inflation, the medium-term trajectory looks comfortable to us.

In particular, we are hopeful that pulses inflation will fall to single digit in the second half of the fiscal as the base effect of last year catches up. Price momentum in pulses should also be aided by the higher sowing pattern observed this year. Obviously, there are medium-term challenges in bridging the demand-supply gap for pulses, but for this year higher production might cut the import dependence, putting a lid on price pressures. Also, we expect the recent rise in vegetable prices (average 7% month-on-month increase in the last three months) to reverse when fresh supply arrives in the market. Overall, we are hopeful that the January 2017 CPI target of 5% is within reach, barring unforeseen supply shocks.

While the inflation trajectory will influence the path of policy rates, the perspectives of the new governor and the monetary policy committee (MPC) will be equally important. Bond markets have started factoring in the possibility of a dovish RBI governor but at this moment it is mere speculation. The key questions are whether the new governor would alter the contours of the flexible inflation targeting framework or can bring in a dovish bias to monetary policy even within the current framework?

A change in the framework can be brought in by altering the inflation targeting benchmark from headline CPI to something like ‘core’ CPI, a convex combination of CPI and WPI (wholesale price inflation), or even nominal gross domestic product (GDP). Alternatively even the target range for CPI (4% +/- 2%) can be changed, as the recent amendment to the RBI Act has kept the door open on this issue. However, it might be too soon to alter any of these parameters given that the framework was agreed less than two years ago. We should be mindful that continuity and credibility are important cornerstones of monetary policy.

Within this broad, flexible inflation-targeting framework, there could still be opportunities to rework the RBI’s response function. Given the stilted cyclical recovery and the persistent banking stress, one way of introducing a softer bias to monetary policy could be to adjust the pace of attaining the final target of 4%. Also, there could be a rethink on the appropriate level of real policy rate in conjunction with the stage of the economic cycle. A third option could be further expanding the liquidity infusion operations to keep the rates depressed. Needless to say, the possibilities of implementing any of these options would arise only if the broad inflation trajectory remains benign. The August monetary policy might not bring in any surprise but the next few months could throw up some interesting debates on the policy reaction function.