RBI hiked the repo rate by 25 bps against the market expectations of a status quo. We believe an outside chance of rate hike had not been entirely ruled out, given both RBI?s penchant for springing a surprise and the recommendations of the Urjit Patel committee report. Going by several policy actions, since September 2013, policy surprises have become the order of the day! The repo rate, if we only go by the RBI Governor?s statement on December 18, 2013, merits an increase (core WPI inched up marginally from 2.63% in November 2013 to 2.75% in December 2013). However, if we look at the long-term trends, an increase may not have been warranted, given that core CPI has remained flat at 8% since October 2013 and core WPI has actually declined from 2.96% in April 2013 to 2.75% in December 2013. So, what prompted the increase?
We believe the primary reason for RBI to increase rates was to ward off the contagion in the financial market. This has been sought to be done to make the arbitrage opportunities between foreign and domestic debt, adjusted for currency risk, more compelling in order to encourage FII debt flows back to India. With Brazil and Turkey already raising rates, there now seems to be a coordinated monetary policy action in January 2014, as was last seen in July 2013. Interestingly, the central banks of Indonesia and Brazil had raised rates in November 2013, and while it was widely expected that RBI will raise rates on December 13, such a hike did not materialise. So, it is entirely possible that the rate hike decision that was paused may have now been prompted with the apex bank watching the global situation very closely. To that extent, and given that the rupee has bounced back in the last two days, the rate hike may have been timely.
The policy statement also reflects a clear recognition of the fact that there are exceptions to the conduct of monetary policy under uncertainty. As was explained by the Governor in December 2013, in an uncertain world (referring to Brainard, 1967), the optimal value of monetary policy instrument depends crucially on the use of more information than what the policymakers may actually conceive (and hence the reference to the December 2013 inflation data softening at that time). It now seems such a rule may not be optimal when the central bank is relatively unsure about the degree of persistence of the inflation process. In fact, the best way to deal with such circumstances is to be aggressive and prompt, ensuring that any adverse shock is not embedded in inflation dynamics despite the uncertainty in transmission parameters.
What are the options before RBI in terms of further rate action? To the extent that such action is purely guided by inflation dynamics, we believe future increases in repo rate do remain an option, however muted. As per our projections, CPI inflation will now be closer to/lower than 8.5% by March 2014?much lower than the 9% forecast by RBI. As per the future trajectory of the CPI, after March 2014, it will be purely dictated by food prices with the onset of summer. Trends from last five years, barring FY11, reveal that the increase in vegetable prices, beginning the month of May, has always been sizeable. But, on the positive side, given that RBI is looking at a CPI inflation target of 7.5%, with a 1% deviation around it in January 2015, the attainment of the number looks more amenable now (remember, the significantly large base effect will also come into play towards the end of 2014).
I would also like to make a reference to the adoption of the Patel Committee recommendations in the monetary policy statement. It is clear that the policy has already adopted the CPI target of 8% and 6% in the medium term, and is moving towards a positive real policy rate. While the Patel Committee suggestions need to be sincerely complemented for the voluminous work, there are some unfinished agenda in the interregnum.
The most important suggestion from the report is that the real policy rate is proposed to be positive. That means rise in inflation above the expected rate will automatically lead to rise in the policy rate. This may not be in keeping with Taylor?s principle: that the response in the nominal interest rate will be in response to both growth and inflation differential above the potential level and expected inflation. In an econometric exercise, such a specification may lead to multicollinearity as a rising trend of inflation will simultaneously harden inflation expectations (through the hysteresis effect). Moreover, to what extent the real policy rate has to be kept positive is not specified for alternative phases of the business cycle.
Interestingly, in the academic literature on the mechanism of achieving the inflation target, there are two distinct approaches: (1) the Conservative Central Banker, a la Rogoff (1985) and, (2) the Optimal Contract Approach of Walsh (1995). While Germany, before the euro, followed the former approach, the latter one was adopted by New Zealand and the UK. The Patel Committee seems to have adopted some properties of both. This may have been done to make it more relevant in the Indian context.
However, the most important thing is that most inflation-targeting central banks do not have goal independence (as the mandate is given by the government) but have instrument independence. This suggested framework seems to have embraced both. It is in this context that it is really important that both the government and RBI work in tandem to make the framework operationally feasible. This will also have the salutary impact of the framework being acceptable to Parliament!
In conclusion, whatever the operational challenges and relevance of inflation-targeting, no one can deny that India can ill-afford such a persistent and stubborn inflation over such a protracted period of time.
Soumya Kanti Ghosh
The author is chief economic advisor, State Bank of India. Views are personal
