Formulating credit policy is always challenging because there is a need to balance various propositions. The most obvious one is the view on inflation. While it is low at 4.7% in April and would probably continue to be so for the next few months, interpretations vary. Normally, one tends to look at core inflation, which also has eased to 5.1% in April from 5.8% in March. But inflation interpretation is malleable, and just like how the concept of ‘core inflation’ came in, one can arrive at a further simulation. If one removes vegetables and edible oils, then the headline inflation rate would be higher at 6.2%. The point here is that inflation is low because of two elements, for which prices are driven by non-monetary factors.
Another area that has to be looked at even while targeting inflation is growth, which is more in line with the Keynesian school than Monetarist. In 2020 and 2021, the Reserve Bank of India (RBI) took the view that it will do everything possible to preserve growth, which means that this is also an objective. The good thing is that the latest gross domestic product (GDP) growth number at 7.2% proves that we are doing very well. RBI now sees GDP growth at 6.5% in 2023-24, which though lower is still impressive.
Besides, as extolled in the governor’s statement, there seem to be many positives for the economy and few negatives. In short, growth will not be a risk factor this year even though the quarterly trajectory would be on a declining trend from 8% in Q1 to 5.7% in Q4. This means growth can be ignored from the monetary policy standpoint at this point. In fact, RBI is very sanguine on all the three critical elements of demand: rural consumption, urban income, and private investment.
The statistician, however, will have a different way of looking at things given that the inflation story is still an enigma. Economic theory says that monetary policy works with a lag, which means that all the action taken so far will bring down inflation in the future. But when will this materialize considering the current low numbers have been brought about by vegetables and oils, which are insulated from monetary policy action? Here, the governor has said that the rate hikes of the past are still working through the system and there would be further downward pressures on inflation in the coming months.
With the uncertainty due to El Niño effects on the kharif crop, there is a major risk to inflation, which has been acknowledged by RBI. This has to be weighed with the fact that inflation is numerically down to less than 5% and will be so this quarter. RBI has not really changed much the inflation forecast trajectory for 2023-24, which it sees at 5.1% for the year. But the statistical effects will make it look low in Q1 at 4.6%, after which it would go back to 5%-plus levels in the next three quarters with Q2 and Q3 being progressively higher.
The problem in interpreting inflation numbers is that they are influenced by base effects, where higher numbers of the previous year lead to lower ones in the year under measurement. This gives the feeling that inflation is coming down, though prices may still be high and may not be easing sequentially, which is the case with most products in the ‘basket of goods considered for core inflation.
A conclusion that may be drawn is that another pause on rates looks likely for the next policy as there will be no real surprise element in terms of inflation being less than 5%. However, as the subsequent two quarters will see readings above 5%, a rate cut in Q3 may also not materialize, with inflation peaking at 5.4% before coming down in Q4. The markets may, therefore, have to wait for Q4 for the first rate cut. Besides, it also appears that other central banks will not be lowering their rates in a hurry, until there is more clarity on the inflation scenario.
The issue of stance is also interesting. It normally is changed to neutral before a rate cut. But the existing stance of withdrawal of accommodation has been retained, which is indicative of two things. The first is that there is plenty of liquidity in the system, which RBI is trying to draw out through the varable reverse repo rate auctions. This will continue until the level comes down to around 1% of net deposit and time liabilities. The second is that the difference between the repo rate and inflation is around 1.8%, which is the real rate. This number is probably acceptable to RBI, and it may be happy with a 1-1.5% difference over a longer period of time. Hence, if inflation stays around 5%, as is forecast by RBI, the markets can expect a 25-50bps rate reduction in the medium term.
The timing, of course, will depend on when RBI will be confident that the monsoon has progressed well and there is no risk of prices going up again. The increases in minimum support prices announced yesterday are significant, and RBI will be watching the impact on inflation. This will be known post-September. The immediate market reaction was unchanged and hence the 10-year yields will remain stable around 7% if the RBI forecasts hold. But short-term yields can be more flexible depending on the state of liquidity, which is presently comfortable thanks to the exchange of ₹2000 notes.
The major takeaway from this policy, which has not changed any lever and only marginally tweaked the inflation forecast, is that it is not yet time to even talk about the timing of, what has of late become a cliché in monetary policy talk, a pivot.
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