Disinflation aims to bring inflation down, while rate cutting aims to support growth. The RBI is aggressively seeking to bring down Indian inflation. But it has now begun to cut rates. Is this consistent with reducing inflation? If and when cuts stimulate growth, will demand and therefore inflation rise?
Transmission of the policy impulse to other rates and to the real sector, whether to price or output, even internationally, is weaker during softening cycles. As Joe Stiglitz wrote - you can pull on a thread but not push on it. In addition, domestic and international research shows transmission through changes in aggregate demand to be weak in low income countries. In India, interest-elasticity of demand is high, however, for categories such as consumer durables and housing, so the interest rate channel will raise demand. It will be slow, however, because of banks' reluctance to cut loan rates. But bank costs do come down as interest rates on new deposits are reduced, so the move to marginal cost pricing of loan rates will speed up transmission of falling policy rates. Apart from a lack of demand and continuing high loan rates, PSU bank NPAs also limit a rise in credit, as does the impact of tight liquidity on informal sector credit. Private and foreign banks' balance sheets are healthy but they tend to concentrate on retail credit.
The exchange rate is another aggregate demand transmission channel. As policy rates fall, a floating exchange rate should depreciate, raising net export demand. But, as a softening cycle raises expected growth, equity inflows can actually rise, appreciating the exchange rate, unless they are absorbed in reserves. Indian interest rates continue to be much higher than those in the rest of the world. Debt inflows are limited by caps, not by the interest differential. Therefore the exchange rate channel also does not work in textbook fashion. The interest rate impact on exchange rates is weak.
The exchange rate channel is likely to be more effective as a cost push channel, since it affects the cost of intermediate goods and food imports. But this channel is also limited, because depreciation required to maintain a competitive exchange rate limits cost-reducing appreciation. Moreover, global risk-on risk-off shocks can cause too much variation in directions unrelated to the needs of the domestic cycle. Volatility-reducing intervention can sometimes damp changes in exchange rate too much.
The aggregate demand channel primarily works by affecting quantities - that is output, since prices tend to be sticky in the short-run. It affects prices over a longer horizon. But in economies that have persistent positive inflation rates, prices are changing more continuously - there is an underlying trend expected inflation rate. Future demand and cost shocks and past inflation behaviour feed into this.
This implies there is an expectation channel of monetary transmission, which is likely to be the most effective in a credibly disinflating the economy. Using this channel requires clear and strategic use of communication. Inflation targeting (IT) regimes require the policy rate to rise with expected inflation. With forward-looking behaviour, if the policy rate rises at least as much as inflation, the real interest rate is positive and cumulative cycles of rising inflation are prevented. But consistent IT must reduce policy rates with a fall in expected inflation. This is necessary to develop an understanding of how IT works. The inflation report must clearly show how changed data affects the inflation forecast, and why deviations occurred from past forecasts. If the inflation forecast is falling, a fall in interest rates is consistent with disinflation.
In India household expectations respond to food and commodity prices, more than to a demand squeeze. Since commodity price shocks are favourable, the government is also undertaking some supply-side action, and the RBI has adopted flexible inflation forecast targeting, there is a real opportunity to guide and anchor inflation expectations downwards. The monsoon has been better than expected and impact on food prices, except for pulses, less than expected. The latter indicates some structural improvements in agriculture. These possibly include moderation of wage growth and low growth in support prices. The latter may have encouraged diversification to producing vegetables and proteins. The government has had some success in improving power and roads in agriculture although better marketing is still work in progress. Soft international food prices will also cap domestic price increases.
Food price inflation has a fast and persistent effect on expectations, in the downward as well as upward direction. Psychological factors make double digit food inflation salient, giving it a larger impact - it leads to second-round effects that sustain inflation. Low food inflation becomes a non-inflationary relative price change. Over 2014-15, there was sharp downward revision in household inflation forecasts. The RBI's inflation forecast can play an important role in further downward shifts. These should not, therefore, show a systematic upward bias, that could come from not adequately revising past forecasts. A credible RBI inflation forecast can be a major focal point because information tends to be thin in a developing economy.The argument that inflation was high for so long, therefore a tight monetary policy is required for as long, is a typical example of backward-looking policy, as is being stuck in a high inflation forecast when inflation is dying. After the global financial crisis there was too little tightening. But too much now will not correct the earlier error - it will only make another one.
In countries like India, moreover, there is also a large share of backward-looking behaviour. In such circumstances, if waiting for data change is delayed too long, macroeconomic instability can occur since action continues to be based on past data, delaying adjustment. Moreover, since the aggregate demand channel does not work well, contributing little to reducing inflation, too high real interest rates impose unnecessary costs.
If inflation drivers soften, not cutting feeds the perception that the RBI is behind the curve, and boosts political lobbies. The possibility of inflation expectations being anchored downwards can keep inflation low, despite rate cuts that help some growth recovery. The latest cut does not indicate any giving up on the inflation fight - only fighting it intelligently.
The writer is a professor at IGIDR, Mumbai
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
