The MPC takes the right call: wait and watch
The inflation outlook and conditions in the financial markets have changed significantly since the last meeting of the monetary policy committee (MPC) of the Reserve Bank of India (RBI). Inflation has surprised on the downside and is expected to remain low in the coming months.
This is partly because of lower-than-expected food inflation and a sharp decline in crude oil prices. The decline in crude prices has also extended the much-needed support to the currency market and helped the rupee recover from its recent lows. Consequently, the MPC, as widely expected, decided to leave the policy rate unchanged on Wednesday. It once again revised its inflation forecast downwards. The rate-setting committee now expects inflation to remain between 2.7% and 3.2% in the second half of the current fiscal, and at 3.8-4.2% in the first half of the next financial year. This basically means that inflation is unlikely to overshoot the 4% target by a significant margin in the foreseeable future, though risks are tilted to the upside.
However, despite the downward revision in inflation projection, the committee decided to retain its policy stance of calibrated tightening. The MPC intends to see whether the current trend is durable to warrant a change in stance.
This newspaper had argued in favour of a rate hike in October against the backdrop of rising crude prices and the falling rupee, which could have potentially pushed inflationary expectations.
Though these risks came down in recent weeks, they have not completely abated, as has also been highlighted by the MPC resolution. The Organization of the Petroleum Exporting Countries (Opec) is contemplating a cut in production, and the condition in the global financial market is likely to tighten in the medium term. If Opec is successful in cutting production, crude prices will go up. Further, a recent statement by US Federal Reserve chairman Jerome Powell on interest rates being just below the neutral rate has been interpreted by many as an indication that the policy normalization might end sooner than expected. This may not be the case. Continued tightening by the Fed and the end of quantitative easing by the European Central Bank will affect the cost of money in international markets.
So what should markets expect? If crude and food inflation do not surprise on the upside, it is likely that the MPC will change the policy stance to neutral in its February meeting. It is also important to note that growth in the second quarter surprised on the downside and most analysts expect it to remain below the RBI's forecast of 7.4% in the current fiscal. A slower-than-anticipated growth in economic activity will also be disinflationary.
However, what is heartening is that, along with increasing capacity utilization, investment activity is picking up and should help contain core inflation, which is running above the comfort level. Therefore, the policy rate is likely to remain unchanged for a prolonged period. Among the potential risks, volatility in crude prices can change inflation projection. If crude reverses dramatically, it will complicate policy choices. Also, a possible fiscal slippage in an election year could change the inflation outlook. The possibility of a rate cut can be easily ruled out in the near term, partly because of the volatility in crude prices. Further, it will be difficult for an emerging market country like India to cut rates in an environment where interest rates globally are expected to go up.
Besides the immediate concerns, at a broader level, some fundamental issues that have been raised deserve policy attention and are worth mentioning here. Ravindra Dholakia, for instance, in an article in the Economic And Political Weekly highlighted issues related to both measuring inflation and gauging inflationary expectations. Dholakia has argued that the present practice of measuring may be significantly overstating inflation. He noted: "...we are measuring our inflation rate in 2018-19 from CPI Combined with the base year of 2011-12. Not changing the base year for seven to eight years in a fast-changing environment can lead to serious errors in measuring the overall inflation rate." Another recent article, again in the Economic And Political Weekly, by S. Mohanakumar and Premkumar showed that the correlation between the minimum support prices of three major crops and retail inflation is statistically insignificant.
Clearly, there is merit in regularly reassessing the way inflation is measured. Also, more research is required in order to develop a better understanding of inflation dynamics. The current weakness in food prices, for example, has surprised the MPC in a big way.