Where does the policy interest rate go from here?
RBI
Watch Monetary
Policy 2014-15
There were no surprises. No change in the interest rate, but
SLR was further reduced by 0.5% to support growth. Please see my note of June 3
after the Second Bi-Monthly statement when I wrote that I expected further
reductions in SLR.
Inflation is now at or below the RBI’s January 15, 2015
target of 8%. It has been so for two
months – June (7.5%) and July (8%).
The RBI is confident of keeping to the 8% target by January
2015, and has now set its sights –it was always there but now it is clearly in
focus - on its next target of 6% by January 2016. Note, since November 2013
inflation has actually trended sharply downwards, but for two months in April
and May, from 11% to 8%! Can we expect a further sharp fall in inflation to the
6% level in the next eighteen months?
Surely, just as interest rate policy had a role in reducing
inflation, weak demand conditions in the economy as seen in the sharply lower
growth rates - partly independent of RBI’s higher interest rate policy - in the
last two years have played a role.
Now the consensus is that investment and demand will pick up
in the coming months and more so into next year. The new government has started
on the path of reforms, and also committed itself to getting its own house in
order (fiscal consolidation). However, bottlenecks in the maintenance and growth of infrastructure
will take the long term to resolve. Also, we have a whole set of structural
factors inhibiting the growth of the agricultural sector – from production to
storage to marketing, which will also take the long term to resolve.
This combination to my mind means that inflation, where food
inflation plays a major role, is unlikely to trend sharply lower, unless
growth, contrary to expectations, continues to be weak both at home and
internationally. If anything, a trend up in inflation cannot be ruled out.
Hence, I do not see any change in interest rate (the repo
rate) by the RBI going ahead. In fact this is necessary to enhance and heighten the RBI’s
inflation fighting credibility at an entirely new level – a goal that Governor
Rajan has clearly set for himself.
This also ties in with the level of real interest rates.
Now, they can be considered to be positive at about 1%. RBI’s credibility as a inflation fighting
central bank needs positive real interest rates – and here it does help that
given the Great Recession of 2008, central banks of Europe, Japan and the USA
have been forced to abandon a positive real interest rate policy for now. However, this will need the support of the
Government.
For a detailed look at monetary policy issues raised in this
note, please see my note of April 16, 2014.
The lengthy post-statement conference calls with analysts
and media are worth wading through. Here are some important comments by Rajan
to questions.
Does the interest
rate differential play a role in interest rate policy?
“My sense is that for the most part we would be driven by
domestic conditions rather than external conditions in determining the interest
rate. Which is precisely why we are fighting very hard to build inflation
credibility, because I think once you get some inflation credibility it gives
you a certain amount of flexibility in focusing on domestic conditions rather
than trying to act kneejerk towards external developments.”
Inflation targeting
and the use of the Taylor rule
“The first, while we have a glide path in mind, I would not
say we are currently in an inflation targeting framework, but we have many of
the elements in place. That said, I think we do look at what kind of policy
would be consistent with a Taylor rule. But remember, Taylor rule is just an
empirical statement based on behaviour of some other central banks, and we
cannot be guided solely by that at this point.”
Real interest rates
and monetary policy
“Real rate, if you take the deposit rate as around 9%, and
you take year-on-year inflation at about 7.5% , 7.3% was last month, we are
into positive real rates and these real rates are certainly on par if not
better with deposit real rates across the world. So, we are getting there in
terms of real rates.”
RBI’s credibility in
fighting inflation
“And fourth, this I do not want to diminish, I think the
expectation that we will confront and deal with inflation is much stronger now
than it was earlier.”
On RBI’s target of
inflation at 8% by January 2015 and 6% by January 2016
“We are confident we can get to 8%, at the current setting
we are also confident we can get to 6% .”
