In a rare interview last Friday, Reserve Bank of India Governor Urjit Patel emphasised the need to ensure that the hard earned gains of macro-economic stability was maintained in order to withstand the global financial volatility. His explanation regarding the change of stance of the central bank was well-timed.
Under his governorship since September last, senior RBI officials have significantly reduced communication through the media. In the absence of any guidance, the central bank had managed to surprise the economists and the market in each of the last three policy meetings. According to a Reuters analysis, Patel gave only nine public speeches or press conferences in first five months of his governorship including one on the disruptive period of demonetisation.
In comparison, D Subbarao, who took over in 2008 at the start of the global financial crisis, spoke 16 times and Raghuram Rajan who started in 2013 amid rupee crisis, spoke 20 times during the same period. Previously, these media interactions were used to ease investors’ concerns and guide the market.
Under the amended RBI Act, the monetary policy decisions are taken by the six member MPC (Monetary Policy Committee) and not by the governor with the help of Technical Advisory Committee. Most probably, the communication strategy of the MPC members needs to evolve over time. None of the MPC members have yet spoken publicly. The absence of communication had increased the volatility in the market.
The monetary policy decision to maintain status quo on February 8 was a surprise because there was an expectation that the RBI might decide to front load its rate cut as the window of opportunity was closing very fast. The backdrop was also just right. India’s growth which was already weak, further slowed after demonetisation.
Investments are yet to pick up and bank credit growth remains muted. Inflation, particularly Consumer Price Index (CPI), softened on falling food-grain and vegetable prices. The government announced a prudent budget with only incremental increase in fiscal deficit to 3.2% of GDP vs the target of 3%. Quality of spending also improved in the Budget.
Global uncertainty is expected to increase with Brexit and new policy decisions of the Trump administration in the US. Crude oil prices are already moving north. The US Fed is expected to hike rates further this year. So, going forward, the external factors will limit the possibility of a rate cut by the RBI. Against this backdrop of uncertain global outlook, weakening local growth momentum, shallow inflation and continued fiscal consolidation by the government, it was expected that domestic factors will weigh higher in RBI’s decision to announce a last rate cut in the cycle.
Of course, the RBI acknowledged the fall in CPI inflation in the past five months. It even lowered the March 2017 inflation forecast from 5% to below 5%. In addition, the RBI lowered its FY17 (April 2016 to March 2017) growth projection to 6.9% from 7.1% announced in December. This baseline projection is lower than the advance growth estimates (7.1%) by the Central Statistics Organisation but higher than the government’s projection of 6.5-6.75% in the economic survey.
RBI stance
However, despite lowering growth and inflation forecasts for FY 17, RBI decided to stand pat on rates. Governor Patel in his interview said that RBI needs to look beyond recent muted headline inflation numbers and focus on trends in core inflation, which excludes more volatile food and fuel prices.
The core inflation has accelerated to around 5.1%, pointing to building price pressures. The stickiness in core inflation could potentially create a floor for further moderation in the headline inflation rate limiting the scope of rate cut.
The bigger surprise came from the change of RBI’s stance from accommodative to neutral. This marks the end of the easing cycle that began in January 2015. A ‘neutral’ stance gives the RBI the flexibility to move in either direction of the interest rate cycle as macro conditions permit.
In FY18, RBI expects negative effects of demonetisation to be transitory and projects a sharp recovery of GDP to 7.4% year-on-year, an increase of 50 basis points (bps) from 6.9% in FY17. It believes that growth will bounce back on the back of increased consumer demand, restoration of activities in cash intensive sectors, lower lending rates and increased public spending in infrastructure and rural economy as outlined in the budget. Moreover, RBI feels CPI inflation would be 4.0-4.5% in the first half of FY18 due to both base effects and demand squeeze.
Inflation will, however, move up to 4.5-5.0% in the second half with adverse base effects and narrowing output gap - higher than the committed target of 4%. There will be upside risks to inflation from high oil and metal prices, exchange rate volatility and higher house rent allowances under the seventh pay commission, which the RBI has not incorporated in its baseline projections. RBI brings ‘Inflation targeting’ to the centre stage with the commitment of lowering inflation to 4% “on a durable basis and in a calibrated manner”.
Inflation and growth are expected to pick up next fiscal. Global factors will become challenging in future with rising oil prices, narrowing interest rate differentials with the US treasuries and increased volatility from US macro and trade policies. Global factors will weigh higher unless domestic data disappoints significantly.
Any future rate action will be data dependent. Focus will remain on transmission of 175 bps of policy rate cuts since January 2015 to the banks’ lending rate. According to Governor Patel, the average lending rates in the banking system have declined just 80-85 bps since the rate cut cycle began. If the RBI could not cut rates when the stance was accommodative, the possibility of rate cut in a neutral stance becomes very unlikely.
(The writer is a research scholar at Indian Institute of Foreign Trade and adviser at Policy Monks. Views are personal)