Sixth Bi-Monthly Monetary Policy Statement, February 8, 2017

Accommodative and neutral policy co-exist

Monetary Policy                                                                           2016-17

The key takeaways are the following:

Inflation in 2017-18 is expected to follow a path of 4-4.5% in H1 and 4.5-5% in H2.

Growth for 2016-17 is revised downwards to 6.9% from 7.1%; growth in 2017-18 is expected to rebound from the temporary effects of demonetisation to 7.4%.

Monetary policy shifts from an accommodating stance to neutral.

There is some commitment by the RBI to bring inflation closer to 4% (the earlier target to get to this March 2018 has been given up), but there is no time frame. The predominant objective is 4%, with a band of +/- 2% in a “medium term” sense (according to me March 2021 based on the Government’s notification).

RBI wants banks to pass on more of the reduction in the repo rate to customers – currently banks have passed on to customers through a reduction in the lending rate about 0.85 % of the 1.75% cut in the repo rate.

The band for the desired level of the real interest rate now seems to have moved up from less  than 1.5 % to 1.25-1.75.

There are no surprises on the inflation and growth front. Recent inflation data suggests that top line inflation is lower than was expected – for the last three months CPI has been less than 4%. RBI expects inflation to pick in FY17-18 back to its normal path, once the temporary deflationary impact of demonetisation wears out.

At the beginning of the financial year, I had predicted that RBI would reduce the repo rate by 0.5%. This has happened, although I was wrong on the timing during the financial year.

At this bi-monthly statement, the last of FY17-18, RBI chose to keep the repo rate unchanged. This is not a surprise.

With inflation projected at about 5% or just below by end of FY17-18, and a target real rate of 1.25-1.75%, a repo rate at 6.25% is appropriate.

What is surprising is the RBI’s shift in monetary stance from accommodative to neutral. While core inflation is about 5%, and there seems to be no let up on this front – much of the recent fall in inflation is because of deflation in vegetables and pulses (demonetisation effects of distress sales by farmers was quoted by RBI) – RBI is concerned that the external factors may pose a risk to inflation – in particular the volatility of the rupee. I had referred to this in my blog of December 15, 2016 as a constraint on the RBI to further reduce the repo rate, if it was felt necessary to do so to counteract larger than expected temporary negative effects of demonetisation.

Some evidence that inflation in the U.S. will rise to 2% , expectations of further increases in the federal funds rate by the Federal Reserve, greater government spending by the U.S. pushing the growth rate higher, can together loop back to depreciate the rupee, which could lead to higher inflation in India.

Note the rupee is arguably significantly overvalued. Please refer to my blog of January 20, 2017 on this subject. It could be that if the scenario above unfolds, RBI may let the rupee depreciate in an orderly manner. And why not: growth needs to pick up at home, inflation is under control, and actively preventing the rupee from falling could use up less foreign exchange reserves.

To my mind, the underlying strong reason for the shift to a neutral monetary stance is that RBI “requires further significant decline in inflationary expectations” to push inflation below 5%. For this to happen, keeping real rates at the top of its band for a considerable length of time in the current environment is necessary. Hence a shift in its real interest band from the less than 1.5% to 1.25 to 1.75% (please refer to the transcript of the conference call with media). Under Governor Rajan, the real interest rate band was higher at 1.5-2%. In this context, please read my blog of October 11, 2016.

Was it necessary for the RBI to communicate a change in monetary stance? I would have thought the MPC could have been silent on this issue. Banks may now hesitate to reduce lending rates.

Where does the repo rate go from here in 2017-18.?

To my mind, if RBI’s projected path of inflation materialises in 2017-18, and RBI sticks to its real interest rate stance, no change in the repo rate can be expected till December. If some of the negative external factors (outlined above) abate, then there is a possibility of a 0.25% reduction in the repo rate in Q4 of 2017-18.