Monetary Policy: If Not Cut Now, When?

Good monetary policy is about nimbleness, not adherence to a strict choreography of rituals, write Abheek Barua and Tushar Arora.

RBI governor Shaktikanta Das interacts with the media in New Delhi, on Jan. 7, 2019. (Photograph: PTI)
RBI governor Shaktikanta Das interacts with the media in New Delhi, on Jan. 7, 2019. (Photograph: PTI)

The fundamental question the Monetary Policy Committee faces as it delivers the policy resolution on Feb. 7 is the following: “if not a rate cut now, then when?” A rule-based model like inflation-targeting introduces a de facto element of data dependence. In our specific case, it means that that the central bank cuts rates when the inflation data is at the lower end of the range and hikes at the upper-end. Granted, inflation targeting is invariably associated with a bias towards rate hikes and a reluctance to cut, but then there is a degree to which a monetary policy authority can retain this asymmetry. The Reserve Bank of India should be seen to follow the rule that it has set for itself. Otherwise, the very credibility of the model stands to suffer.

Inflation hawks will invariably turn to the business of a ‘forward-looking’ policy. Nonetheless, any extrapolation, however conservative, based on past data is likely to yield a subdued path for inflation, well into this year, and would justify easing. Arguments such as the RBI needing to change its stance first and then cut rates are somewhat misplaced.

Good monetary policy is about nimbleness, not adherence to a strict choreography of rituals.

There is, of course, the issue of sticky and high core inflation. Even as the headline inflation has been lower than the RBI’s target of 4.0 percent for five straight months, core inflation, which excludes volatile items like food and fuel, has remained stubbornly high at 5.5 percent.

Should then the high core inflation number influence the RBI’s actions? The answer to that should be obvious. We have consciously chosen headline CPI as our target, not core inflation. This is unlike other central banks, like the U.S. Federal Reserve that categorically targets the core personal consumption expenditure deflator. For the RBI, it would be difficult to justify a decision that ignores the target and focuses instead on a component of it.

The Consequences Of Being Late

Moreover, the longer this period of low headline inflation persists, the greater is the risk of second-round effects, as people start to build this low inflation into their expectations. This could have wider implications for the economy in the form of considerably low wage growth and weak pricing power.

In extreme cases, a collapse in inflation expectations could even erode the incentive to produce.

Thus to set the expectations right, it is best that the central bank avoids complicating the communication and proactively responds to headline inflation signals.

This is not to say that there are no risks to the upside. State governments with their vote-catching loan waivers and hefty expenditures by the centre on agriculture—including the minimum income scheme for the farmers—might reverse the fiscal trajectory. But the mitigants are just as important to highlight – oil prices are likely to remain soft because of tepid global growth, capacity utiliSation might have increased for some sectors but pricing power at a broader level seems tame, and finally emerging market inflation over the past two years have been on a downward path and converging towards developed market inflation.

The ‘output gap’, that the RBI fears is compressing, remains an enigma.

However, one must not forget that the standard approach for calculating the potential output as a simple extrapolation based on past trends has its own flaws, especially when there is adequate evidence of surplus labour and falling wages in the labour-intensive sectors like farming.

In this context, it might also be worth looking beyond the traditional measures—which are solely based on potential output—and instead focus on the finance-neutral output gap. This approach evaluates the sustainability of economic growth based on financial sector developments, captured by movements in bank credit, real interest rates and trends in the stock market.

Just like a negative output gap acts as a guiding principle to ease monetary policy, existence of a negative finance-neutral output gap suggests that there is room to be accommodative for the central bank.

At present, given that there is some slack in the financial sector due to the lingering NPAs, dismal credit disbursal to the industrial sector, and subdued trends in the stock market, the finance-neutral output gap measure is still negative, making the case for a cut that much more compelling.

Abheek Barua is Chief Economist, and Tushar Arora is Senior Economist, at HDFC Bank. Views are personal.

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