Rate cut calls for raising red flags

Last week saw the first rate cut in 18 months. The RBI’s Monetary Policy Committee (MPC) cut the policy repo rate, which influences the rate at which banks lend to customers, to 6.25% from 6.5%. This came along with a change in the policy stance from ‘calibrated tightening’ to ‘neutral’. Most market participants did not expect a rate cut at this juncture, but they did expect the change in policy stance. The cut came in the very first policy announcement after Shaktikanta Das took over as RBI Governor and the last policy announcement of this fiscal.

The MPC has given its reasons for the rate cut. Among these are the CPI inflation rate of 2.2%, the lowest in 18 months. Some 30% of the foods group (vegetables, sugar, pulses, eggs and fruits) are in deflation. Core inflation (headline inflation rate minus food and fuel inflation) is down to 5.6% (December 2018) from 6.2% (October 2018). Household inflation expectation has softened by 80 basis points and 130 basis points over a three-month horizon. A moderation in rural wages and the assumption of a normal monsoon add to this list.

As Das put it: “The path of inflation has moved downwards significantly and, over the period of the next one year, headline inflation is expected to remain contained below or at the target of 4%. This has opened up space for policy action…The favourable macroeconomic configuration that is evolving underscores the need to act now when it is most opportune.”

The approach marks a sudden change in favour of a rate cut though the underlying scenario remains broadly the same as during the time of the December resolution. The sea-change in approach can be seen on several counts.

True, we have a benign inflation outlook, but the outlook was equally benign in December. Survey results by the RBI now indicate a sudden softening of the 12-month horizon of household inflation expectations, which were at an elevated level earlier. There is a lack of recognition of the elevated level of core inflation, which truly reflects the persistence of inflation. The MPC’s mandate is to look at headline inflation but in doing so, it cannot ignore important components of it, like core inflation.

Further, the MPC has recognised but not acted on uncertainty in the fuel price and upward risks of reversal in food inflation. There is a mellowing down on how they view fiscal slippages and renewed optimism on monetary policy transmission.

Under the inflation-targeting framework, the MPC is charged with keeping inflation at 4% with an upward or downward band of two percentage points. One crucial factor in the policy framework is the inflation forecast as the intermediate target. Therefore, the credibility of monetary policy action critically hinges on the accuracy of the forecast.

The continued deceleration of headline inflation was on account of a substantial reduction in food and fuel inflation. There are uncertainties on the fuel -- price of crude -- front. Similarly, there could be a reversal of deflation in food prices.

Survey data on inflation expectations, particularly for 12 months ahead, need to be seen in the context of the earlier survey. Das said that regional offices participated to make the survey broad-based this time. The question that remains is how, in a short period of two months, the survey results could take such a U-turn.

Though the MPC mandate is on headline inflation, the elevated level of core inflation is a matter of concern and needs to be addressed. A complete denial of this development is detrimental to the overall credibility of the monetary policy.

Disturbing development

Fiscal slippage has been a routine feature in the Union Budget. It has been a convention with the RBI and MPC to recognise the fiscal slippage explicitly, but in this MPC resolution, the fiscal slippage has been assumed to be a non-disruptive element. This is a disturbing development.

It is important to mention that the economic cycle has not changed in so dramatic a manner in a period of just two months that the monetary policy stance could be changed from calibrated tightening to neutral, with a rate cut, to boot.

Transmission of monetary policy has been a serious concern for RBI. Earlier RBI governors are on record saying that the policy repo rate cut has often not translated to a cut in bank lending rates, thereby making monetary policy redundant.

The MPC resolution says that, “output gap has opened up modestly as actual output has inched lower than potential”. In the earlier resolution, the MPC took a view that the output gap is closing. In this resolution, without changing the growth outlook and keeping it the same, at 7.4% for 2019-20, the statement that actual output is lower than the potential is not convincing.

There is a popular saying: “Torture the data, and data will yield.” This is a trap. One wonders if the MPC has fallen into this trap by announcing the rate cut.

(Pattnaik is a former central banker and a faculty member at SPJIMR) (The Billion Press)