The new monetary policy committee (MPC) has spoken in one voice. The unanimous decision announced on 4 October to cut the repo rate by 25 basis points to 6.25% surprised me a little, I have to say, in light of the several upside risks to inflation listed right upfront in the monetary policy report. Prominent among these is the potential impact on house rent of the Seventh Pay Commission
allowances for Union government employees. But actually, that by itself is the least cause for worry since it will not have all that great an effect on the national index. The effect on house rent and a lot else besides will begin to show when the new scales work their way through state governments, and government-run universities and research institutions all over the country. Then, of course, there is the announced 42% rise in minimum wages by the Union government, which will also work its way through the system, and its inevitable spiral through the minimum support price for public food procurement.
The statements of individual members justifying their vote will be made public 14 days after the MPC meet, which took place on 3-4 October. The MPC is not yet fully formed. The seat in the MPC for the deputy governor handling monetary policy fell vacant when Urjit Patel became governor. The deputy governor now holding charge of the function, R. Gandhi, is a Reserve Bank of India (RBI) official. There is no statutory bar on this situation continuing indefinitely, but there is a post-reform convention of appointing a deputy governor from outside the RBI who is a trained economist and takes over the monetary policy function.
This practice grew in response to the greater independence and importance of monetary policy post-reform, and gains added force in the present circumstances. But then again, there are three outside economists now on the MPC, so maybe the RBI will decide to carry on with that vacancy unfilled.
The MPC is pledged to contain inflation at a target of 4%, with a tolerance band of 2% above and below it. Whatever the long-term advantages claimed for this statutory shift to prioritizing the objectives of the RBI, the short-term advantage is that it scores very highly with credit-rating agencies. These agencies, on which sovereign governments depend for their financial survival in a globalized world, like to have their work reduced to boxes they can tick. The formal commitment to inflation-targeting has gained sage nods of approval, along with ticks on that box, although India is yet to see a rise in its credit rating.
The amendment to the RBI Act nested in the Finance Bill of 2016 requires the RBI to issue a monetary policy report on inflation every six months, with forward projections for a period from six to 18 months. This may not appear very different in substance from the inflation cone (or fan) which has accompanied all monetary policy statements in the past. But the big difference is that the RBI now carries primary responsibility for deviations of actual inflation from the permissible range, and has to justify why that happened, what will be done to rectify it, and the time period over which such correction will be achieved.
This last statutory responsibility has huge potential consequences. So far, monetary policy statements have felt free to point to fiscal deficits at the Centre, or to the need for executive action to contain food prices, while reporting on price movements in the economy and the correctives needed. That kind of thing will no longer pass muster.
Responsibility is now uniquely assigned to RBI to administer correctives even if other actors in the economic system are going rogue. If the Seventh Pay Commission salaries will work their way through all states and state-run institutions, RBI can no longer point an explanatory finger at that process. It has to administer medicine that will contain the price impact of that increase in salaries.
Failure to meet the inflation target is defined in the gazette notification of 27 June as crossing of the upper tolerance level of 6% for any three consecutive quarters. I would have thought a statutory definition of failure in that manner would have made the MPC risk averse, but its first decision does not reflect that.
The ultimate textbook benefit of a formal inflation target, credibly delivered, is the taming of inflationary expectations, down to equivalence with the target. RBI has been conducting (urban) surveys of inflationary expectations every quarter, and these findings are publicly available on the RBI website. It is one of the many things that make it such a great central bank.
The surveys show expectations continuing to reign high, even as the consumer price index (CPI) has shown a sharp decline. Over the period June 2015 to June 2016, when actual inflation rates fluctuated in the 3.7-5.8% range (year on year), the median expectation of inflation one year ahead from the survey never fell appreciably below 10%. These are displayed in a chart in the latest monetary policy report.
The results from the September survey of urban households’ inflation expectations, reported in the monetary policy report just issued, show that the median expected inflation rate one year ahead has risen even further, to 11.4%. These surveys are confined to urban households, but the CPI inflation rates for urban India have consistently been below those for rural India. So presumably, rural expectations are higher still.
What keeps the inflation expectations of respondents to these surveys so high? Experimental studies in economics show how a recent feature in any situation can have an impact out of all proportion to its actual importance on a more reasoned consideration. A spike of the kind we recently had in the price of arhar dal, for example, could have an impact on inflation expectations far out of proportion to the actual weight of that item in the overall index (0.8%). And if there is a succession of spikes in onion prices yesterday and tomatoes tomorrow, the experience of shifting volatility could add a risk premium to expectations.
But then, the surveys also report perceived (current) inflation at rates considerably above those calculated from the CPI. We need a better understanding of how inflation perceptions and expectations are formed.
The taming of inflationary expectations is the key link to the real economy benefits of holding wages predictable and steady, and thereby attracting the investment that will improve the productivity and competitiveness of the economic system. It is possible that in India, bringing down the rate of inflation is necessary but not sufficient to bring down expectations to equivalence with the targeted rate. Volatility in key food items with a low weightage in the index, but key perceptional importance, also needs to be contained.
Even though the MPC notification gives the sense that its sole task is inflation control, we happen to be in the midst of an easing cycle in monetary policy over the last 21 months, thanks in part to the oil price crash in mid-2014, and in large part to improved food management. Given those wholly fortuitous developments, monetary policy entered into an easing phase beginning January 2015, driven by the broader real economy considerations of an economy mired in low rates of investment and poor employment generation.
The expansionist path has had a gentle and guarded gradient, but this is the context into which the MPC is entering—and which to the surprise of all it has carried forward. The key consideration, in this easing cycle, is monetary transmission. There are two stages in that process. First, changes in the repo rate have to be transmitted to the operating target, which is the call money rate—the rate at which banks borrow on the market for overnight liquidity. The mean level of the call rate relative to the repo rate, and the volatility of the call rate around its mean need to be watched closely since these shape the nature of the monetary signal itself. There was a welcome formal shift of attention to this issue starting with the policy statement of April.
At the second stage, the monetary signal from the call rate has to be transmitted by banks to their borrowing clients. There are many well-known potholes on that road.
The only statutory responsibility handed to MPC members is their vote on the repo rate. They are also required to “write a statement specifying the reasons for voting in favour of, or against the proposed (MPC) resolution”. This could be a tiresome obligation if all they are expected to do is to write down why they voted as they did on the repo resolution.
But nothing prevents them from using it to larger purpose, turning their attention to call money volatility or any other matter of relevance to their task, including their observations on the model underlying the inflation forecasts in the monetary policy report.
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