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RBI should adopt core inflation targeting; calibrated tightening to stay
The persistent focus of the RBI and the markets on headline inflation is a misnomer in the context of monetary policy management. It is high time that the RBI starts articulating its stance based on core inflation. Given the sticky nature of core inflation, it is unlikely that the RBI will change its “calibrated tightening” stance in a hurry unless unanticipated negative demand shocks lead to a 100-200bp decline from the current 6% plus. As of now, most lead indicators cited by the RBI suggest an upside risk to core inflation.
Calibrated tightening appears contradictory to scaling-down of inflation projections
The steep 120bp reduction in inflation projection by the RBI in its Dec 5 policy announcement to 2.7-3.2% for H2FY19 and 3.8-4.2% in H1FY20 (Exhibit 6) is seen as a signal of an impending shift in policy stance back to neutral in the coming months. The decision to keep the policy repo rate unchanged at 6.5% along with a calibrated tightening stance appears contradictory given that it is already anticipating a steep decline in forward inflation. Indeed, the Governor has hinted that if the perceived upside risk to inflation does not materialize, it would open up space for rate action. The market has extrapolated these signals as an imminent rate easing in the coming policies, especially in the context of the sharp 30% decline in global crude oil prices from the Oct peak of USD84/bbl.
Headline inflation is a flawed indicator; core inflation more relevant :
We believe that the confused interpretation of the RBI’s stance is rooted on the flaw that the monetary policy committee bases its monetary policy assessment on headline retail (CPI) inflation, which is a wrong indicator. For most mature central banks, the relevant target variable is core inflation, which strips out the volatile and transient components such as food and fuel. However, our assessment suggests that while most of the RBI’s communication is focused on headline CPI inflation, its rate actions appear to be aligned with its outlook on core inflation, reflecting the true inflationary situation. For instance, the calibrated policy stance is probably in lined with the RBI’s observation that core inflation has remained sticky and is getting broad-based at 6.1% for the month of Oct’18 (Exhibit 1). Hence, in our view, there is an urgent need for the RBI to switch to core inflation targeting instead of the volatile headline inflation targeting.
* Responsiveness of repo rate to headline inflation is low :
Indeed, the responsiveness of the RBI repo rate to the lags of headline inflation is found to be very low (0.25-0.30 for every 100bp rise in inflation; Exhibit 2) ever since the RBI has adopted price stability as its target objective. In contrast, the responsiveness of the policy repo rate to core inflation is significantly high and rises lags; from 0.63 to 0.91 over lags of 1 to 5 months. Hence, the shocks in core inflation gets completely factored into the RBI policy rate action over a period of six months.
* Low spillover of volatile non-core components on core inflation :
Our analysis also shows that the impact of non-core inflation, i.e., inflation in food and fuel, on core inflation is very little. The cumulative lagged sensitivity of non-core inflation on core inflation over six months is less than 0.20 and is statistically insignificant (Exhibit 11). Considering the current level of core CPI inflation of 6%+ what it means is that if the transient non-core inflation remains low, the RBI is unlikely to change its stance in a hurry. The risk for the non-core inflation is that it could rise with an expected sudden rise in the inflation of perishable food items and a renewed hardening in global crude oil prices.
* Core inflation at 6%+ much higher than the RBI’s long-term target of 4% :
The above assessment also suggests that the long-term inflation target of the RBI of 4% (+/- 2ppt) is associated with core inflation rather than headline inflation, which factors in the volatile noncore components. Thus, the more relevant core inflation at 6.1% is significantly higher than the central target of 4% and above the upper limit of the RBI’s comfort zone. Probably, this interpretation justifies the RBI holding on with its calibrated tightening stance. Over the past five years, core inflation has averaged at 5.3% and has dipped just below 5% only during 2015-16 (Exhibit 3).
Real repo rate is much lower than neutral level of 2%
The relevance of core inflation remaining higher than the long-term target of 4% also implies that the real policy repo rate has remained mostly lower than the targeted real rate of 1.5-2.0%. For instance, the real repo rate (repo rate less core inflation) currently stands at 0.4%, with an average of just 0.6% during 2018. Hence, on the basis of real rate comparison, the policy rate has been less than neutral (Exhibit 4).
India real rate similar to the US, but inflation gap positive vs. negative for the US
Considering a global comparison, the US Fed, whose policy rate is aligned with core PCE inflation, the real Fed rate of 0.25% (2.25% fed rate less core PCE inflation at 2%) is also much lower than the median estimate of neutral real rate of 1%, i.e., the level at which the Fed rate is considered neither tight nor loose; Exhibits 8-10). Hence, with the US Fed guidance of four hikes till the end of 2019 of 3.25%, the Fed rate will be only marginally higher than the neutral level of nominal Fed rate of 3% (2% inflation and neutral real rate at 1%). The contrasting thing is that while the US core inflation is still a tad lower than the 2% target, India’s core inflation at 6.1% is way higher than the 4% inflation target of the RBI. Yet, the real rate for India at 0.4% is only marginally higher than that of 0.25% for the US.
It’s high time RBI shifts to core inflation targeting; calibrated tightening likely to stay
The persistent focus of the RBI and the markets on headline retail inflation is a misnomer in the context of monetary policy management. It is high time that the RBI starts articulating its policy stance based on core inflation, the de-facto core indicator it appears to be following. In addition, given the fact that the core inflation rate has remained sticky, it is unlikely that RBI will change its “calibrated tightening” stance in a hurry. The shift in stance toward neutral can only arise if there are unanticipated negative demand shocks that lead to a sharp decline in core inflation by 100-200bp from the current 6% plus. Such responses were seen at the advent of demonetization (Nov 2016) and GST dislocation (mid-2017).
As of now, most lead indicators cited by the RBI suggest an upside risk to core inflation. These include improved pricing power of manufacturing firms, above-average capacity utilization in the manufacturing sector, a rise in the purchasing manager index, a surge in non-food credit growth to 15.6% in Nov’18 higher than nominal GDP growth, and most importantly, a low output gap (i.e., actual GDP growth less potential growth).
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