RBI Policy: At A Crossroads

Inflation is poised for a meaningful undershoot but much will depend on the Monetary Policy Committee's macroeconomic assessment and the symmetry of its loss function.

The minutes of the April MPC meeting revealed a committee that remained cautious about the stickiness of core inflation and worried that the softness of food inflation was largely demonetisation-induced, thereby expecting a swift payback in the summer months. Back then, monsoon concerns were building up, oil had crept back up to $55 a barrel, and markets were convinced that Fed normalisation was well on course, with hikes in June and September pretty much in the bag.

Much has changed since then, and almost uniformly in one direction. The most visible of which is that food prices have not picked up sharply this summer as had been feared, despite their collapse over the winter. That is one of the key reasons why inflation undershot expectations in April, and is on course to print in the 2 percent handle over the next three months and, more generally, average less than 3 percent in the first six months of the fiscal year – meaningfully below the RBI's 4.5 percent forecast.

There are two ways to interpret this. One is that this evolution is purely idiosyncratic and that inflation will eventually mean-revert, and possibly sharply. An alternative interpretation is to appreciate that the sustained food disinflation over the last two years remains an unsung hero.

After averaging 11.0 percent between 2007 and 2013, food inflation has averaged just 4.5 percent since the start of 2016.

Structural Underpinnings?

To be sure, weak rural demand has likely contributed to the softness of food inflation (the ‘Engel Effect') – thereby reversing what happening in the mid-2000s. But four years of sustained food disinflation, across food groups and two droughts, suggests there is an under-appreciated structural component to the disinflation, likely underpinned by the relatively muted increase in minimum support prices in recent years, debottlenecking of supply chains for perishables, and pro-active imports to augment domestic shortages.

On core inflation, too, risks have ebbed to the downside. We have long maintained that the right measure to gauge core inflation is to strip out petrol and diesel prices from the standard core measure, to generate ‘core-core' inflation. Core-core has declined over 100 basis points (1 percentage point) over the last year to print at a series low of 4.1 percent in April. Furthermore, this now ties in nicely with the revised gross domestic product series. The revised GDP trajectory is finally consistent with a host of high-frequency data that reveal an economy that was already slowing before demonetisation, and the slowdown intensified in the second half. This now explains why core-core inflation has been slowing since the start of 2016. Negative output gaps since 2016 have likely been larger than believed.

Furthermore, our view is that any recovery from here is going to be tepid at best as investment is weighed down by stressed assets in the banking system; as the agricultural growth mean reverts to 2 percent from the near-5 percent last year; and the consolidated fiscal impulse remains contractionary. Exports remain the key upside risk but, notwithstanding this, we remain slightly more sanguine about the trajectory of core-core inflation going forward.

Global Risks

At the margin, global risks also appeared to have ticked down. Two soft core inflation prints in the United States (suggestive of an increasing flat Phillips curve) and a soft jobs report in May, may not imperil a June hike by the Fed. But they are expected to induce much more dovish Fed commentary at the June meeting, and also raise some questions around a September hike. Unsurprisingly U.S. Treasury yields, after peaking at 2.6 percent in March, have been on a sustained downtrend and are now trading below 2.2 percent.

Similarly, despite the Organization of the Petroleum Exporting Countries (OPEC) signaling more cuts, oil prices are back at $50 a barrel. All this just confirms that the oil market has fundamentally changed.

We have gone from having a floor for oil prices to having a ceiling determined largely by the progressively-reducing break-even for shale. 

All these factors, along with the monsoons starting off normally, suggest that inflation risks have clearly ebbed down since April and should mitigate some of the concerns that the MPC had when it appeared squarely focused on the upside risks to its 5 percent inflation target.

Also Read: Economists See RBI Holding Rates Even As Inflation Concerns Abate

What To Watch In The MPC Commentary

How much comfort the MPC derives from these developments will depend crucially on its (i) current macroeconomic assessment and its view on what quantum of the disinflation is cyclical versus structural; and (ii) the symmetry of its loss function.

For starters, is the MPC convinced that the food disinflation will sustain, and thereby have a depressive impact on expectations? Or does the MPC still worry that food inflation will eventually mean-revert, and possible sharply? Similarly, does it believe that the growth slowdown in the last two quarters is purely transient, induced by demonetisation, and therefore the economy will bounce back sharply in the coming quarters? This belief is likely embedded in its gross value added forecast accelerating sharply from 6.7 percent in 2016-17 to 7.4 percent in 2017-18. Or have downside risks emerged to the MPC's growth trajectory, in light of recent developments and the latest GDP release? Finally, is the MPC slightly more comforted by global developments – the Fed and commodities – or does it still worry about the pace of Fed normalisation?

The second is the symmetry of the MPC's loss function. In the early stages of inflation targeting, central banks are much more inclined to err on the side of caution, to help anchor inflation and inflationary expectations. The loss from inflation undershooting targets is deemed to be less than the cost of an inflation overshoot until the credibility of the new regime is firmly established. As inflation targeting gets more entrenched, and expectations get more anchored, loss functions typically become more symmetric, and the risk of an undershoot is deemed to be as costly as that of an overshoot, especially if output gaps are still negative. In India's case, one could argue that inflation targeting is still in its infancy, but also that output gaps remain negative. Therefore, the symmetry of the RBI's loss function, or the lack thereof, will be a key determinant of how the MPC reacts to any undershoot. The more asymmetrical the loss function is, the more convinced the MPC needs to be of an undershoot before pulling the trigger.

Also Read: The Risk Of Rushing Toward An Inflation Target Prematurely

Room For Modest Easing Opening

So what does all this mean for the June review? With inflation expected to undershoot forecasts for another year, we believe space for modest easing is opening up later in the year.

At this week's review, however, we expect MPC to stay on hold and indicate it is monitoring macroeconomic developments and the progress of the monsoon, in particular. Furthermore, because any easing is likely to be modest and opportunistic, we believe it's unlikely the MPC will change its stance from neutral to accommodative (the latter typically being suggestive of an easing cycle). Instead, we expect the MPC will strike a softer tone, and acknowledge that the risks around its inflation forecast are more balanced, or even skewed to the downside, thereby setting the stage for modest easing later this year.

Sajjid Z Chinoy is Chief India Economist at JPMorgan.

The views expressed here are those of the author's and do not necessarily represent the views of BloombergQuint or its editorial team.