The growth projections for 2013-14 have been revised downward by the Government, the RBI, multilateral financial agencies as well as foreign and private banks.

The question is whether another round of repo rate tightening is called for in this scenario.

The downward revision of growth estimates is attributed to a multitude of reasons, such as political uncertainties associated with impending elections, structural bottlenecks, poor supply response, depreciation of the rupee, weak industrial activity feeding into the services sector and the uncertainties associated with QE (quantitative easing) tapering.

The central bank and RBI have different priorities, which obfuscate the policy scenario. Stubborn retail inflation and depreciation of the currency seem to be guiding monetary policy actions, which, of late, have assumed a hawkish trend.

WEAK SENTIMENTS

In its last Mid-Quarter Monetary Policy Review on September 20, 2013, the RBI increased the repo rate by 25 bps to bring down inflation, though it acknowledged that industrial activity was sluggish.

The hike in repo rate was guided not only by high retail inflation, but also by upside risks to WPI on account of pass-through of fuel price increases, sharp depreciation of the rupee and elevated international commodity prices.

The rupee-dollar exchange rate had been quite turbulent, reaching new lows in the three weeks preceding the policy review. The Indian basket of crude oil remained at around $110 per barrel during the month preceding the policy review.

While the hawkish tone of the September 20 policy can be appreciated, a pause rather than hike in policy rates could have served the purpose — particularly when sentiments were weak and interest rates were already elevated.

PRICE INDICES

The second quarter monetary review is due on October 29, 2013. Notwithstanding the downward revision in real GDP growth, market players are expecting another round of rate hikes.

Their expectations are guided by the possible change in monetary policy anchor to the CPI (consumer price index) from WPI (wholesale price index); the persistence of CPI-based inflation in the double digit range, despite significant softening of WPI-based inflation, adds to this perception.

The constitution of an expert committee to examine the current monetary policy framework under the chairmanship of the Deputy Governor of the RBI, Urjit Patel, on September 12, 2013, has added to such speculations.

A debate is in progress on whether monetary policy should work with WPI as its anchor or the CPI. Inflation measured through WPI has moderated but CPI-based inflation has remained around 10 per cent for 18 months.

Traditionally, the RBI considered the WPI as the headline measure of inflation because legacy consumer price indices (CPI-industrial workers, CPI-agricultural labourers, CPI-rural labourers) represented prices relevant for different segments, rather than for the entire population.

In an attempt to capture retail inflation on a pan-India basis, the CSO began compiling three new measures of CPI, viz., CPI (Urban), CPI (Rural) and CPI (combined), from January 2011 onwards.

The year-on-year inflation measures based on the new CPI are available since January 2012.

So, should the RBI continue to use WPI as the anchor for monetary policy? The case against using WPI is that it captures prices only at the wholesale level, rather than retail prices. Further, WPI does not adequately capture movement in the prices of services, which make up more than 60 per cent of the GDP.

CPI LIMITATIONS

Former RBI Governor D. Subbarao had rightly pointed out that focusing on CPI reflects the welfare objective of monetary policy better. However, he cautioned against using CPI for monetary policy for three reasons.

First, the new CPI inflation series has only 20 data points, which is not sufficient for statistically robust analysis. Second, food prices comprise nearly 50 per cent in the new CPI index, making it extremely sensitive to food price changes.

Third, it is not clear whether prices of services are being captured correctly. As food articles have a dominant weight, higher CPI inflation reflects a spike in food-related articles, as they are in short supply. Monetary tightening can curb price pressure arising out of excessive spending, but really cannot help in increasing supply of food products.

INFLATIONARY EXPECTATIONS

Despite limited utility in controlling CPI through tight monetary policy, the RBI has been maintaining a tight monetary policy to control inflationary expectations.

Effective tackling of inflationary expectations would require ruthless tightening, which can lead to a major slowdown or a recession.

The Volcker regime in the early 1980s tried to bring down inflation by working on expectations, but as a result the US economy entered into a deep recession.

In a mature economy where living standards are high, with explicit support for possible unemployment arising out of recession, the use of monetary policy for inflationary expectations is workable.

However, in India, it would be politically difficult to apply monetary policy to work through expectations.

It is fashionable for researchers and analysts to recommend monetary tightening to contain inflationary expectations, in the interests of sustainable growth.

However, low growth can further deepen slowdown impulses.

A more practical approach to gauge price pressure in the economy will be to use the quarterly GDP deflator-based inflation as the benchmark.

As the chart shows, GDP-deflator based inflation numbers are less than the CPI, but more than the WPI-based inflation.

These numbers indicate that there has been a perceptible decline in price pressure since the quarter ended September 2012.

However, as GDP deflator-based inflation is available with a lag of a quarter, daily data on liquidity, currency movements, international oil prices and monthly data on WPI, CPI, IIP, trade and credit growth can be used to fine-tune policy in the mid-quarter and quarterly reviews.

GDP deflator as the anchor, and minor tweaking to accommodate incoming data will help to optimise monetary policy reaction.

Such an approach would help in better management of inflationary expectations.

(The author is Professor, Xavier Institute of Management, Bhubaneswar. Views are personal.)

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