Even as markets and analysts may quibble about the implications of the monetary policy decision, and what it means for the future path of interest rates, it's important not to get caught in the minutiae, and not to miss the forest for the trees.
For starters, the decision was landmark because it was made by a six-member monetary policy committee (MPC), which culminates in a remarkable transformation and institutionalisation of the monetary policy framework in the short span of three years. As recently as in 2013, the Reserve Bank of India (RBI) was governed by a multiple-indicator approach that made it virtually impossible to glean what the overarching goal of monetary policy was -whether it was growth, inflation [and, if so, whether Consumer Price Index (CPI) or Wholesale Price Index (WPI), headline or core), the exchange rate, or financial stability, or what combination thereof. In just three years since then, the RBI has decisively moved to targeting headline CPI inflation, made public commitments to achieving numerical targets, the RBI Act itself has been amended, and a six-member monetary policy committee has been set up and made its first interest rate decision. This is ground-breaking institutional reform for which the government and the RBI deserve enormous credit, we believe.
Second, it's increasingly clear that inflation has seen a durable moderation in India. Consider this: Despite successive droughts, food inflation has averaged 5.5 per cent over the last 24 months versus an average of 11 per cent in the 24 months prior to that. What this suggests is that some part of the food disinflation is clearly structural. Yes, benign global food prices have helped. But, arguably, the restraint shown on minimum support prices (MSP) since 2013, and improved supply bottlenecks (manifested in a lower amplitude and duration of vegetable price spikes) have been key contributors to the food disinflation. No wonder then that the RBI has more comfort, that on the back of the normal monsoon and strong sowing, food inflation should remain contained. More generally, our research shows the disinflation of headline CPI is not largely because of the good luck from lower oil prices. Indeed, we find that global factors account for less than 30 per cent of the disinflation. Instead, lower MSPs, improved supply bottlenecks, the new monetary policy framework, and moderating inflation expectations have been key to the disinflation. It's hardly surprising that the RBI forecasts inflation to moderate further to 4.5 per cent by March 2018, barring any impact from the Housing Rent Allowance (HRA) from the 7th Pay Commission or a goods and services tax (GST) standard rate that is set meaningfully above 18 per cent.
This is not to say there are no inflation risks on the horizon. While the RBI can be expected to look through the direct mechanical impact of the HRA increase or a GST-tax related increase, second round effects should not be taken lightly in an economy that witnessed six years of double-digit CPI inflation from 2007 to 2013 and where households - scarred by that experience -remain wary of sustained price increases. Second, with consumption expected to be the main engine of growth over the next year (underpinned by the central and state pay commissions, and some recovery of rural consumption post the normal monsoon), investment will have to begin to do its share of the heavy lifting. Imbalanced growth - led only by consumption - may not meaningfully pressure manufacturing inflation (given the relatively low capacity utilisation rates), but it is likely to pressure services inflation, which has been sticky around the five per cent mark.
All said, we still expect more room for easing to open up in the coming months. Led by the food price decline, we expect headline CPI to print close to 4.5 per cent in September and dip to four per cent by November. While some mean-reversion in the January-March quarter is natural, we think the odds have now increased that - on the back of the normal monsoon and strong sowing - headline CPI will likely undershoot the five per cent target by March, thereby opening up some more space for easing in the coming months. Given the prevailing uncertainties, the MPC was understandably cautious and signalled upside risks - albeit less than before - to its five per cent, March 2017 target. In our view, the risks are more balanced and, in fact, skewed slightly to the downside.
Finally, after the rate cut, much was made about the RBI "abandoning" its neutral real rate target of 1.5-2 per cent. We have long maintained that the Wicksellian neutral real rate - like potential growth - is very much a dynamic construct. It's impossible to claim that there should be a fixed real rate across all states of nature. Instead, the neutral rate is a function of the economy's potential growth, changing preferences, technology and structural characteristics (for example, increased financial inclusion should argue for a lower rate, all else equal), global equilibrium rates, to name just a few factors. Furthermore, it's not even clear whether the current interest rate in India is at its long-run equilibrium -which, by definition, occurs when output gaps are closed and inflation is at its long-run target. Output gaps are still negative in India (as manifested by low capacity utilisation rates) and inflation is still above its four per cent medium-term target. So it cannot be presumed that current rates are necessarily at neutral.
All told, it's easy to get lost in the weeds about the equilibrium real rates and near-term inflation dynamics. The larger fact is that inflation in India has halved over the last three years, and the current monetary policy framework - now enshrined in law - should ensure that never again will Indian households have to experience double-digit inflation for six years, as was the case between 2007 and 2013. For that, we should be eternally grateful.
The author is chief India economist, J P Morgan
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
