CIRCUIT BREAKER. Why RBI has turned a perma-hawk

Former Reserve Bank of India Governor Raghuram Rajan was reviled for his reluctance to trim benchmark interest rates, to give a helping hand to the Indian economy. After digging in his heels in the first year, he eventually relented, lowering policy rates by a significant 150 basis points between January 2014 and January 2016.

Now it turns out that his successor is more hawkish. After an initial cut of 25 basis points in October, policy rates have remained on hold in the last seven months. The past week, the Monetary Policy Committee and RBI have been receiving more than their usual quota of brickbats, after deciding not to trim interest rates on June 7.

The angst is understandable. The markets had been primed for a rate cut ever since the CSO’s latest GDP data painted a dire picture of economy for the fourth quarter of 2016-17. And the MPC has also offered up a jumble of unconvincing arguments to justify its hawkish stance.

But it is not the personalities in question, but the new Monetary Policy Framework Agreement inked between the Centre and RBI in February 2015, which needs to be blamed for RBI’s consistently hawkish stance in the last couple of years. Here’s why.

First and foremost, the agreement has made price stability the lynchpin of RBI’s monetary policy. Prior to it, RBI used a multiple indicator approach and could weigh growth, inflation and exchange rates to decide on interest rates.

Two, the agreement has committed RBI to an extremely conservative inflation target. The agreement has explicitly bound RBI to bring inflation below 6 per cent by 2016-17 and required it to sustain it within ‘4 per cent plus or minus 2 per cent’ in ‘all subsequent years.’ With inflation having dipped below 6 per cent in 2014, RBI has been gunning for 4 per cent since.

Three, the agreement holds RBI solely accountable for any misses vis a vis the target. It explicitly states that, if the retail inflation rate strays beyond the range for three consecutive quarters, RBI needs to put in writing, the reasons for the slip-up and the remedial actions proposed to be taken. It even needs to specify the period within which inflation will fall back in line.

The onerous obligations under the agreement may still have allowed RBI some wiggle room, had the inflation target been pegged at more realistic levels.

History tells us that a 4 per cent retail inflation target is quite a hard ask in the Indian context. Taking stock of the new series of the Consumer Price Index (CPI) which was flagged off in January 2012, we find that the monthly inflation reading has been at 4 per cent or below it only in 9 out of 64 months. Put simply, retail inflation has remain at or below 4 per cent only one-seventh (14 per cent) of the time. But this data does not cover multiple economic and global cycles. How often has India experienced 4 per cent or lower consumer inflation rates in the last twenty years? Well, studying the data on CPI – Industrial Workers, which has a much longer history, tells us that monthly CPI inflation at 4 per cent or below only 23 per cent (less than one-fourth) of the time.

In fact, if you average the monthly inflation rate over the twenty years from 1997 to 2017, you find that the ‘normal’ level of retail inflation in India is 6.8 per cent. The most frequent inflation print (the mode for the series) is 5.3 per cent. So, given that actual retail inflation rates have been a good 100-200 basis points above the 4 per cent target, it’s no surprise that RBI has gone into a default hawkish mode ever since the agreement was inked.

But what made the Centre adopt the 4 per cent target in the first place? And why is the RBI keen to contain inflation at 4 per cent, even though it has a 200 basis point leeway to go over it?

Well, the number (as also the decision to move to an inflation targeting approach) was mooted by an expert committee (ironically) chaired by Dr Urijit Patel in January 2014. When the committee was constituted, India was just coming off a decade of exceptionally high CPI inflation (it averaged 10.1 per cent in 2008-2012).

High retail inflation rates were then seen as the villain of piece in impoverishing low-income earners, denting consumer confidence and prompting savers to flee from financial investments. In those circumstances, bringing down retail inflation rate to 4 per cent probably appeared to be a very desirable goal. Statistical analysis also showed that 4 per cent was the inflation level at which the Indian economy displayed a zero output gap (no excess capacity).

Stiff targets apart, there’s the question of how much influence RBI really wields on price trends in the economy. While the agreement seems to assume that all the RBI has to do is to shift the rate lever for inflation to fall into place, the reality is much more complex.

In India, ‘core’ inflation components, for which demand is inelastic and RBI has limited ability to tame prices using monetary instruments, make up 57 per cent of the CPI. This ties the RBI’s hands in influencing the CPI numbers as quickly or effectively as it would like.

Then, there’s the fact that RBI has a surfeit of data to gauge price trends in the economy, but very little data on evolving growth and employment trends.

Unlike the US, where the Fed can access monthly data on non-farm payrolls, reliable employment data in India (NSSO and Labour Bureau survey) is available once in a blue moon and with a multi-year lag.

This impels the central bank to respond promptly to runaway inflation, while putting off action to tackle a severe slowdown.

Falling inflation over the last three years has also demonstrated that very low inflation is not very easy to digest for the aspirational Indian economy.

It is after all inflation that decides income growth for salary earners, crop prices for farmers and revenue and profit growth for India Inc. Inflation also helps the Indian government improve its fiscal metrics by piggybacking on high nominal GDP growth.

All of this suggests that, if the Centre is keen to see a more dovish RBI, it should revisit the Monetary Policy Framework Agreement to shift that inflation target a few notches higher.

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