A question of monetary policy credibility

The minutes that detail what members said at the Feb. 07 Monetary Policy Committee (MPC) meeting which led to the lowering of the policy repo rate were released to the public as per the schedule on February 21, 2019. In the best of disclosure traditions, this release is precisely 14 days after the meeting of the MPC.

In the resolution under reference, the MPC decided to reduce the policy repo rate by 25 basis points to 6.25 per cent (4:2 votes) and unanimously it was decided to change the monetary policy stance from what is called “calibrated tightening” to “neutral”. In plain language, this means the pointer on rates stands in the centre and could move either way going forward.

The headline Consumer Price Index Combined, both rural and urban (CPI-C) is the official measure of inflation of India. Under the inflation targeting framework, the MPC’s mandate is to achieve a medium-term target of CPI-C inflation of 4 per cent within the band of +/- 2 per cent, “while keeping in mind growth”

Thus, in an operational sense, generally inflation and growth outlook as projected by RBI guides the MPC members to take a considered view on the policy repo rate. In a practical sense, we, of course, know how pressure is mounted to reduce rates on the often simplistic thinking that this is alone will drive growth.

How do the MPC and the RBI look at inflation? It can look at past data but that will not tell it much. It can look to the current number and still not be well informed by the dynamic on the ground. So, what the experts on the MPC and in the RBI do is look to the future. The inflation outlook critically hinges on the inflation forecast by the RBI. Besides, when it comes to inflation, it is the inflation expectation that plays a critical role.

This simply means that if people expect prices to go up, their consumer behaviour will be such as to actually achieve that expectation since more will prefer to buy today rather than tomorrow at a higher price. This will fuel demand and drive prices up. The MPC also looks at growth. On the growth outlook, the critical item is a term called the “output gap” (that is the difference between actual output and potential output).

Now consider that at the December bi-monthly meeting, all the members were of the opinion that inflation was benign but the outlook on inflation was not in the comfortable zone. The RBI inflation expectation survey of the households of one-year ahead was expected to be at an elevated level.

Now, how has this changed in a span of two months at the February meeting? This time, the inflation forecast has taken a ‘U’ turn and so also the inflation expectations. More surprisingly, the output gap was described as having closed in December 2018 – which means we were producing to capacity. In two months, from the December 2018 meeting to the February 2019 meeting, the actual output came in as lower than the potential output.

How did members react to these inconsistencies? To begin with the inflation outlook, the following views are worth noting. While Dr Michael Patra, a career Central banker who is a member of the MPC, opined that “inflation forecast is likely to course below 4 per cent up to the third quarter of 2019-20, thus securing the target over a one-year ahead horizon”, another member Dr. Chetan Ghate commented that the RBI’s projections are “sensitive to the assumed momentum on food inflation”. He further commented that softening of inflation has not happened in a broad-based way.

Anchoring inflation expectation is an important element in monetary policy. Two MPC members, Dr. Ravindra Dholakia and Dr. Pami Dua justified the moderation in inflation expectation. Deputy Governor Dr. Viral Acharya, however, mentioned that “anchoring of inflation expectations households is still an ongoing process and it is somewhat early to assume its sustenance going forward based on the most recent adjustments.” He also mentioned lack of adequate and sustained downward adjustment in house hold inflation expectations over the past 12 months.

Another important issue is the one on core inflation (which is headline inflation minus food and fuel inflation). While Dr. Ghate and Dr Acharya showed concern on the elevated level of core inflation, according to Dr Ghate, “the elevated level of ex-food and fuel continues to be challenging despite the fall from 5.8 per cent to 5.6 per cent.” Expressing his concern on core inflation, Dr Acharya mentioned that he remained concerned about the elevated level of inflation excluding food and fuel.

Dr Dholakia mentioned that the core inflation is coming down and shows a declining trend in India “because the inflation targeting regime in India has resulted in anchoring of people’s inflation expectations and as a result the core inflation is declining”.  The growth in the February MPC resolution for 2019-20 was projected at 7.4 per cent. The new RBI Governor in this context mentioned that “space has opened up for policy action to address growth concerns in pursuance of the provisions of the RBI Act as amended in 2016.”

He said: “The favourable macro economic configuration that is evolving underscores the need to act decisively. The time is opportune to seize the initiative and create a congenial environment for growth to revive and ensure sustained trajectory”. Dr Dholakia raised the issues of higher “real policy repo rate” at 2.6 per cent, a higher negative output gap and argued for a policy repo rate cut.

There are several questions that emerge from the foregoing. First, should the idea of a “real policy rate” be looked into at all? Is it the mandate of the MPC? Second, should the persistence of inflation in core inflation be a red flag and given due importance in deciding the policy action or not? Or should the MPC look into headline inflation only? In this context, the RBI may undertake a fresh technical study on persistence of inflation and the linkage with core and headline.

Third, is growth revival contingent on policy repo rate cut given that this cut rarely and never swiftly transmits to the lending rate of banks? Fourth, how strong is the predictive power of inflation forecast by the RBI? And if there is some error, what is the systematic part and how much is random? This is important because the inflation forecast is the intermediate target and the decision to take action on policy repo rate is based on the intermediate target.

Fifth, what is the strength of the inflation expectation survey? Some analysts have expressed doubts on the results. Sixth, what about fiscal slippage, crowding out and dis-savings by the government working as hindrance to higher growth trajectory. An RBI study on this will be helpful and will encourage a healthy debate.

At the end of the day, the monetary policy critically hinges on credibility and right now, with swift changes and different lenses seen in two back-to-back MPC meetings, there are some issues of credibility that cannot be swept under the carpet.

R K Pattnaik is a former Central banker and faculty member at SPJIMR. (Syndicate: The Billion Press)

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