Why inflation has the RBI on its toes

Headline inflation has been receding steadily and current readings are below the January 2015 target of eight per cent as well as the January 2016 target of six per cent. "Accordingly, the central forecast for CPI inflation is revised down to six per cent for March 2015" "risks to the January 2016 target of six per cent appear evenly balanced under the current policy stance."

These quotes from the latest RBI policy statement surely reveal that inflation has improved beyond expectations and is expected to remain within the four plus or minus per cent band for the next 15 months. Is that not sufficient grounds for a rate cut?

Apparently not. The RBI has chosen to leave policy interest rates unchanged as it remains wary of inflation rising again on three counts. One, the positive base effect may wear off from December onwards. Two, there could be a sharper seasonal rise in food, fruits and vegetable prices in the first quarter of 2015 consequent upon poor kharif harvest and lack of clarity about Northeast monsoon. Three, inflationary expectations surveys still come up with low double digit figures, thought the policy statement keeps silent on the crucial issue of the direction of these expectations.

Inflation

On the flip side, there are a larger number of factors supporting a rate cut. One, not merely the global crude oil, but indeed commodity prices across the board are plummeting and expected to remain soft during 2015.

Two, with a four point five per cent increase in minimum support prices for major cereals, agriculture prices including that of fodder and feed are likely to rise only moderately, thereby keeping dairy and protein prices in check.

Three, both rural and urban demands have shown significant weakening, which implies lack of pricing power with manufacturers. Hence, falling input prices are bound to be reflected in lower output prices sooner rather than later.

Four, real interest rates are now firmly in the positive territory, especially if one looks at the difference between prime lending rates and the WPI. This difference better captures the real cost of capital faced by investors.

Five, a majority of sectors are straddled with excess capacity so that there are minimal chances of prices rising in line with demand over 2015.

With arguments balanced on either side, the RBI has chosen to be ultra cautious. It clearly sees merit in establishing itself as an inflationary hawk. Shelving the rate cut by a few months seems to suggest that the RBI will wait for the government to first undertake the necessary structural reforms that will raise the rate of growth of potential output.

In postponing the cycle of monetary policy easing, could the RBI end up in beating down investor sentiment to such an extent that it becomes comatose? Can the present practice of the RBI and the ministry of finance reacting to each other via public policy announcements not be replaced with a better synchronised policy response? Why is it incumbent upon us in India to slavishly follow the western model of overt central bank autonomy? China does not follow this practice and the PBOC and Chinese ministry of finance act in concert both for macro policy management as well as management of the financial and banking sectors. We should learn from the Chinese in many spheres and this is one of them.

Investment

At present investment activity is at a crawl; credit off take from banks is well below deposit growth; and Q2 saw gross fixed capital formation is at a standstill. Non-food credit off take has in fact been declining month over month since April. The RBI is, of course right in asserting that interest rates are only one of the factors that affect investor sentiments and activity. Other factors include the demand outlook, business environment, procedural bottlenecks; uncertainty in the taxation regime; availability of necessary factors of production like land and labour at acceptable prices; and the risk and return profile for future projects.

However, the RBI must know that the government is now seized of these various aspects of improving investment climate and these are all works in progress. Therefore, the RBI could have as easily chosen to signal, through a rate cut, that it is on board in further improving the investment climate.

That would give the government some leverage vis-a-vis the political opposition and something to show to the investor community. As it has now played out, the RBI seems to be saying that they would rather not give the benefit of the doubt to the government and is therefore exercising utmost caution. Has the RBI chosen to completely ignore the objective of raising investment and growth in anticipation of soon emerging as an exclusive "inflation targeter"?

Policy

Commercial banks are flush with funds but apparently do not face any competitive pressure to lower their lending rates. The RBI itself points to this excessive liquidity with commercial banks by pointing out that "banks" recourse to the Reserve Bank for liquidity through net fixed and variable rate term and overnight repos and MSF declined from Rs 803 billion, on average, in Q1 to Rs 476 billion in October-November.

The use of export credit refinance also declined sharply during October and November. But no lending rate cuts have been forthcoming. It is time therefore for the RBI to pay more attention to improving the competitive environment in the banking sector, integrating the badly fragmented financial markets and establishing a more effective monetary policy transmission mechanism.

Finally, it is surely time for all those concerned with policy making to bring employment generation in to their reference framework. While the US Fed constantly refers to the employment situation in the US in the context of determining its policy stance, this is all together absent in the RBI’s policy statements. This is incomprehensible. Employment generation must surely be the top priority in a country where 12-15 million jobs have to be generated each year to absorb new entrants to the labour force.

Monetary policy can contribute to this highest policy priority by paying more attention on exchange rate management and ensuring that real effective exchange rate at least remain constant. This will positively help promote labour intensive exports. These factors militate against inflation targeting becoming the exclusive driver of monetary policy.