Two weeks ago, the Reserve Bank of India (RBI) surprised many by keeping its key lending rate—the repo rate—unchanged, making it amply clear on which side of the line the central bank stands in the growth-versus-inflation tug-of-war.
This was not entirely unexpected.
In December, in its second policy, barely a month after the government had made the stunning demonetisation announcement, the monetary policy committee (MPC) led by RBI governor Urjit Patel had maintained a status quo on rates, when hopes were for the contrary.
On Thursday, in an interview to Rahul Joshi, Network 18 Group Editor-in-Chief, Patel reinforced the point on why it was important to look through the headline inflation number.
Sticky core inflation
India’s inflation rate has remained well within the RBI’s tolerable threshold limit of 6 percent. It was 3.17 percent in January—a level that some analysts see as symptomatic of poor demand and weak economic activity caused by the cash crunch.
Patel, however, cautioned about two unknowns on the inflation front: fuel prices and the remonetisation effect.
Fuel prices have started rising from January after the Organisation of Petroleum Exporting Countries (OPEC)—a cartel of oil producers—agreed to cut back production. The resultant fall in supplies should push up crude oil prices from its current historic lows, eventually leading to higher diesel and petrol pump-gate prices in India.
This, in turn, could fan overall inflation rates. Patel reckons the headline retail inflation rate could steadily climb back to 5 percent levels in the second half of 2017-18, limiting the RBI’s ability to cut interests further.
Besides, non-food, non-fuel inflation, or what economists refer to as “core” inflation, remains sticky at close to 5 percent levels—a primary reason why the MPC decided to change the stance from “accommodative” to “neutral”, meaning a lower chance of a rate cut in the near future given growing inflation risks.
“Internationally, commodity prices have firmed up, the international food price index has gone up, the base metal price index has gone up, crude prices continue to be in the mid-50s and staying there for some time given the data of the past few months,” Patel said.
“So, the MPC noted that while inflation will be in the range of 4-4.5 percent in the first half of the next fiscal year, it then actually increases to 4.5-5 percent. That was one of the main reasons why we had to take the stance that we did, that while we will have some beneficial impact on inflation in the next few months, it then reverses itself mainly because inflation, excluding food and fuel, continues to be relatively high,” he said.
The bigger unknown, however, was the effects of demonetisation, and subsequent “remonetisation,” on food inflation.
The currency recall has forced families to spend less, depressing the demand for some goods including perishable products since November.
Growth in consumer food price inflation (CFPI), a metric to gauge changes in monthly kitchen costs, moderated to 0.53 percent in January from 1.37 percent in December and 6.67 percent in January, 2016, reflecting how the cash crunch has hurt demand for both perishable and processed food items.
Prices of vegetable and pulses appear to have been worst affected by restricted access to cash.
The growth in consumer price index for vegetables, contracted to (-)15.62 percent in January from 6.39 percent during the same period last year. It was (-)14.59 percent in December.
Patel believes this disinflation will likely be transient as cash gets quickly replenished in the banking system because of “remonetisation”, engineering a quick demand pick-up.
“The effects of the demonetisation and now, the remonetisation also may impact some of the commodities where we have seen disinflation, but we do not know to what extent and for how long. It is most likely going to be short-lived,” he said.
“For example, the disinflation in vegetable prices and therefore, the headline number needed to be looked through keeping in mind that we need to get closer to 4 percent on a durable basis, but in a calibrated manner. And that was the reason the MPC thought that we needed to have the flexibility going forward and therefore the shift of the stance from accommodative to neutral,” he said.
The RBI and the government have set a retail inflation target of 4 percent for the next five years with an upper tolerance level of 6 percent and lower limit of 2 percent.
The RBI expects the Indian economy to grow at 6.9 percent in 2016-17, lower than the Central Statistics Office’s advanced estimates of 7.1 percent, but higher than many other forecasts including the Economic Survey’s 6.5 percent estimate.
Importantly, the RBI expects growth to recover sharply to 7.4 percent in 2017-18 on account of several factors — a rebound in discretionary consumer demand as more cash comes back into the system, revival in in cash-intensive sectors such as retail trade and the unorganised sector, lower rates because of surge in demonetisation-induced bank deposits, and greater government capital expenditure as outlined in the Union Budget.
“Almost everyone agrees that the impact is going to be a sharp “V”, that we would have a downgrade of growth for a short period of time,” Patel said.
“There are some good reasons behind that recovery. One is that international trade, especially exports, after a long time, are now showing some life. We have had 5 months of positive export growth. I think the Budget has provided impetus to key sectors which has multiplier effects – realty-, housing, the rural segment. Over time we will see that some of the capacities that had been installed in the past will come up for expansion. So, private investment demand is something that maybe in the second half of this year will give a fillip to the recovery,” Patel said.
The surge in bank deposits, greater digitisation and spread of the formal financial system has a positive spinoff for investments, although it moves at a slower lane.
Financial inclusion has a direct correlation with overall economic growth — a useful guide in times of slowdown. As more people open bank accounts, India’s savings and investment rate will only rise. Higher investment feeds into growth. For instance, as banks were forced to open up branches in remote areas, after their nationalisation in 1969, India’s savings and investment rate rose steeply from 13 percent in the early 1970s to about 25 percent of GDP in about 15 years.
Pressing the accelerator on financial inclusion can possibly yield similar results now, especially when India has cemented its place as among the world’s fastest growing major economies.
“We have also had financial re-intermediation, in terms of greater financial savings going into deposits, mutual funds and insurance. So, there have been a fair number of benefits. Even the impetus given to digitisation should be beneficial going forward,” Patel said.
Among demonetisation’s many objectives, “from the RBI side, the fake Indian currency note is an important issue that needed to be addressed”.
“The other collateral benefits from this, in terms of greater accountability, better public finance, more transparency are by definition areas that take time to fully play out. But, I think in all these supportive policies, more work is needed so that these benefits are not only tangible but are long-lasting and durable,” the RBI Governor said