On the face of it, it may seem odd that RBI chose to hike policy rates by 25 bps after staying on hold at the December review. For, since then, headline CPI and WPI inflation have moderated 130 bps, food prices continue to correct, the anticipated industrial rebound at the end of 2013 did not materialise, and the government appears determined to stick to its budgeted fiscal deficit target, which will be a further drag on growth in the current quarter. Given all this, markets had begun entertaining the prospect of rate cuts later in the year. Another rate hike must seem like a bolt from the blue.
But dig a little deeper and one can fully appreciate why RBI acted. The guidance from its December pause was explicit. Headline and core inflation (with core CPI stuck at 8% for the previous six months) were too high for comfort. For RBI to stay on hold, both had to moderate. The first condition was met. Vegetable prices have corrected sharply in December and January?pulling down the headline rate with it. But core CPI inflation did not budge, remaining at 8% for a seventh successive month. From the perspective of a central bank?s credibility, there?s no point giving explicit guidance if it will not follow through on it. Had RBI not acted, markets would have accused the central bank of crying wolf and future guidance would have been discounted. To its credit, RBI acted decisively.
It is tempting to shoot the messenger?that the new CPI series is untested and has a short history. But a simple way to test whether it?s a simple measurement issue is to look instead at the CPI-Industrial Workers index?one with a much longer history and widespread acceptance. As it turns out, the picture does not change. Average core CPI between September 2012 and September 2013 (the last month for which data is available for CPI-Industrial Workers) is 8.3 % while that for the new CPI is 8.2%. So this is much more than a measurement issue.
Instead, the real macroeconomic puzzle is why is core CPI stuck at 8% when growth momentum continues to weaken. The only way to reconcile stubborn core inflation?in the face of weakening growth?is to come to the grudging acceptance that India?s potential rate of growth has, unfortunately, reduced markedly. In a world in which every major region (US, Euro Area, China) has seen its potential been downgraded and a world in which India?s corporate investment to GDP ratio has fallen 8 percentage points over the last 4 years?with its attendant implications on productivity growth?its not hard to see why India?s potential has fallen much more than presumed. So, output gaps are not as negative as presumed. And slowing growth, by itself, may not be enough to bring inflation down to acceptable levels. More medicine was needed, as the RBI Governor indicated at the press conference.
The other reason why core inflation may not be moderating in tandem with growth is that inflationary expectations have become so entrenched that they are impeding the transmission process. Small changes in the output gap (slack) may not be enough to convince wage and price setters that inflation is going to moderate. Much more slack will need to be created to bring inflation and inflation expectations down. Economics refer to this as the Phillips curve flattening. Put simply, the cost of disinflation is getting higher. And the longer that high inflation creeps into our psyche, the greater this cost will be.
It?s against this back-drop, that RBI needs to be commended for signalling a significant departure from the extant multiple-indicator approach at yesterday?s review. One of the problems with the multiple-indicator approach was that nobody quite knew what the goal was?was it growth, or was it inflation, or was it the exchange rate? In the case of inflation, was it headline or core? CPI or WPI? If sophisticated financial market participants could not de-code RBI, economic agents on Main Street had little chance.
The central bank, therefore, needs to be commended for effectively moving closer to a flexible inflation-targeting framework based on the headline CPI?committing to a glide path to bring headline CPI to below 8% in a year?s time?based on the recommendations of the Urjit Patel Committee report.
The beauty of a transparent, quantitative medium-term target is that economic agents can use that to anchor inflation expectations. And everybody is clear as to what RBI is trying to achieve in a year?s time.
The term ?inflation targeting? is not particularly appealing in India. Because it connotes that somehow the central bank is ?choosing? inflation?over other developmental objectives such as growth or the exchange rate. That?s a fair assessment if inflation is in the 4-5% range and there is truly a trade-off between stimulating growth in the short-run and temporarily accepting higher inflation.
But when retail headline inflation has averaged 10% for the last 6 years and core inflation has averaged 9% over that period of time, there is no trade-off between growth and inflation. Such elevated inflation levels disproportionately hurt the poor?who have least access to indexation instruments?thereby squeezes their purchasing power and impinging on consumption. High inflation is invariably volatile inflation, but not all prices move in tandem. So relative prices get distorted, investment gets discouraged and allocative efficiency is badly compromised. No country in the world has seen high and sustained growth with inflation at the levels India has experienced the last few years. And with inflation expectations so entrenched, it is no wonder that households find comfort in physical assets and financial savings bleed. High inflation also reduces external competitiveness and puts downward pressure on the currency. One can go on and on but the bottom line is there is no trade-off between inflation and growth or inflation and other developmental objectives at current levels of inflation. Bringing inflation down from current levels will be growth enhancing, not growth inhibiting.
It?s against this backdrop that the central bank must be commended for deftly moving closer to flexible inflation targeting?one that will not tie its hands from responding to shocks and other objectives in the short run?but one that will create an anchor in the medium-run.
Markets are likely to obsess on whether the action was hawkish or the guidance was dovish. But the real message from yesterday?s review appears to be that the transition to a more transparent, rule-based monetary policy framework at the central bank, with price stability as its overarching medium-term objective, is well and truly on.
The author is Chief India Economist, JP Morgan, and served as a member of the Urjit Patel Committee on strengthening and revising the monetary policy framework
