RBI sees demonetisation as a non-event: Prescience or helplessness?

Fifth Bi-Monthly Monetary Policy Statement, December 7, 2016

Monetary Policy                                                                                                     2016-17

Not altogether a surprise that the Monetary Policy Committee chose to keep the repo rate unchanged at 6.25%.

In my blog of November 25, 2016 on the November 8 demonetisation of Rs. 500 and Rs. 1000 notes and the uncertainty it had created for the growth of the economy in FY 2016-17, I had expressed the view that a reduction in the repo rate was likely, unless the rupee comes under significant pressure. The rupee did come under significant pressure, falling at one point by over 3% against the U.S. dollar since the last policy announcement on October 4. In its outlook, the MPC noted that ‘U.S. monetary and fiscal policy could impact volatility to the exchange rate thereby feeding into inflation’ – the term ‘volatility’ being the RBI’s euphemism for weakness, in my view.

Significantly, the RBI sees the effects of demonetisation on the growth of the economy as purely ‘transient’. In theory this is true as demonetisation is simply the substitution of one set of notes by another happening without lag and friction.

Although, the RBI has reduced its growth target for the year from 7.6% to 7.1%, in the words of the Executive Director in the conference call with media, only 0.15% of the reduction is due to demonetisation. The remaining 0.35% is due to the lower than expected number of 7.1% for growth in Q2 FY 2016-17. Perhaps the RBI feels that it has no hard data points as yet on the effects of demonetisation on growth, despite the widespread media reports about the difficulties faced by most sectors and people in accessing cash, and the consequent slowdown in spending.

On the inflation front, there is no change in RBI’s projected inflation path – 5% by March 2017, with risks to the upside, although lower than the October policy review.

If this is the picture that the RBI has of the economy for the rest of FY16-17, then its decision to make no change in the repo rate is warranted. But is this picture correct? It is hard to believe, at least based on media reports, that this is the case so far as the growth of the economy is concerned. What about hard data points?

On December 9, the RBI released fortnightly data on credit and deposits in the banking sector. In FY 2016-17 up to November 25, credit grew by just 0.6%! At the end of two quarters, i.e. up to September 30, 2016, credit grew by 3.7%, less than the 4.2% seen in the same period during the previous year.

So from September 30 to November 25, bank credit actually fell - by Rs. 2,282 billion.  Significantly most of that fall - Rs. 1672 billion - it appears happened even before the demonetisation on November 8!

On the inflation front, where RBI did not have the benefit of hindsight, data was released just two days ago which showed that consumer price inflation for November came in at 3.63%, well below expectations. Does this suggest a softer inflation path than RBI’s current one going into March 2017? Clearly one data point is not sufficient. The RBI is in a wait and watch mode.

It is quite a surprise that at the MPC meeting all members unanimously agreed that no change in the repo rate is warranted.

Meanwhile, some banks have cut their deposit rates and a few their lending rates.

One weakness with the MPC’s assessment and past statements is that it does not show trends in bank credit and deposits, money supply and reserve money on a regular basis - even though the RBI is directly attempting to influence both the price and flow of money in the economy through its monetary policy actions. This is necessary.