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The monetary policy committee (MPC) will decide its next move this week. The committee’s October meeting was held under the shadow of five main risks.
First, global oil prices had soared in the previous months. Second, the sharp decline in the rupee would increase the cost of imported goods. Third, strong economic growth in the first quarter of the current fiscal year had closed the output gap. Fourth, it was unclear how the government’s decision to increase farm support prices would affect food prices in general, especially when combined with the fact that the monsoon this year has been well below average. Fifth, there was a question mark about the sanctity of the annual fiscal deficit target.
Each of these could feed inflation, ending the surprisingly benign spell of the past few months. However, a lot has changed since the October meeting. Oil prices have retreated, the rupee has seen a small recovery, the economy seems to have slipped into a cyclical downturn and food prices remain muted. Only one of the risks that worried the members of the MPC in October seems to linger on—the fiscal situation. The big question before the MPC’s decision this week is how the changed circumstances will affect its inflation forecast, which is the intermediate target of Indian monetary policy under flexible inflation targeting.
The Reserve Bank of India (RBI) has already reduced its inflation forecast twice this year. It is among the many central banks around the world that has overestimated price pressures in recent quarters. In the Indian case, the surprise has come from food prices. Core inflation is running far ahead of food inflation, which is to be expected as excess capacity in many parts of the economy has shrunk.
The analytical puzzle is whether core inflation will move down towards food inflation, food inflation will move up towards core inflation, or the gap between the two will persist. Especially important will be the new data on inflation expectations of households that are known to adapt to recent trends in salient prices such as food and fuel rather than being anchored near the inflation target.
The RBI had said in its October monetary policy report that it was changing the baseline assumptions being used in its inflation forecast model. The Indian basket of crude oil was assumed at $80 a barrel rather than $64 the central bank had assumed in April. The rupee would be at 72.50 to a dollar as against the April assumption of 65.50. The RBI had also said that inflation would ease by an estimated 20 basis points in case crude oil prices came down to $72. The price of a barrel of Brent crude is now at about $60 while the dollar trades at below 70 to a rupee.
As the September 2015 monetary policy report noted: “Timely and accurate forecasts of growth and inflation play a critical role in the conduct and formulation of monetary policy. If the assumptions underlying these forecasts undergo drastic changes, actual outcomes may deviate substantially from the initial forecasts.”
The current combination of benign inflation as well as slower economic growth means that there is no reason at all for the MPC to increase rates this week. Many of the risks that seem to have dominated the MPC discussions in October have receded.
The consensus in the financial markets is that the finger will continue to be on the pause button, and the focus of attention will be on whether there are any moves to reduce the liquidity deficit in the money market as well as a change in the stance of monetary policy. The market for overnight index swaps is now signalling only one rate hike in the fiscal year beginning April 2019, as against three rate hikes embedded in the October prices.
The committee had changed its outlook from neutral to calibrated tightening in October, in effect saying that the next change in the repo rate would be through a rate hike rather than a rate cut. It had faced a lot of criticism when it moved its stance from accommodative to neutral in February 2017, but the subsequent trajectory of inflation showed that the MPC had made the right call. It is not clear whether the recent shift to calibrated tightening will also prove to be a right call in case volatile food prices catch up with core inflation.
Both the Economic Survey 2017 as well as the monetary policy report released in September 2015 discussed how central bank inflation forecasts have overestimated future inflation. This is a big challenge in the flexible inflation targeting framework since the MPC considers the inflation forecast as the intermediate target of monetary policy. Some of the uncertainty in future inflation is also captured in the wide bands in the inflation fan charts that the RBI releases, with a range of almost 6 percentage points at a 90% confidence interval.
Average inflation in the past three month has been a percentage point lower than the three months before that. The price pressures that loomed large over the MPC in October seem to have dissipated for now.
There is thus a strong reason for the MPC to keep policy interest rates at their current level—though it will be worth watching whether any individual member shifts his or her recommendation from either a hike to pause or from a pause to a rate cut on Wednesday.
Niranjan Rajadhyaksha is research director and senior fellow at IDFC Institute.