Hitting hard on inflation

The Monetary Policy Committee (MPC) has hiked the policy repo rate by 25 basis points, taking it to 6.5%. This is the first time we have a situation where the MPC has increased rates at two consecutive meetings. Thus, the policy repo rate which, over time, drives the rate at which banks lend to customers, has moved up from 6% to 6.5% in the last four months.

The MPC wants this increase to “bite” (in the words of the RBI deputy governor and MPC member Viral Acharya) so that inflation is checked. What this tells us is that there is a nagging, underlying strain on the inflation front.

The retail inflation rate, measured in terms of the Consumer Price Index, was at 4.9% in May 2018 and 5% in June 2018. This headline number is at a level higher than the inflation target of an average 4% that the MPC is mandated to maintain. The inflation number looks uglier when we calculate core inflation, which is the headline number adjusted after removing sensitive items like food and fuel.

Core inflation has been on an uptick since the beginning of the current fiscal and has remained at a higher level of 6.53% in June 2018. Items like housing, education, health and recreation and amusement broadly form part of core inflation. Officially, the MPC does not talk of core inflation, but this calculation informs its understanding of headline inflation, which is the target the MPC looks at.

The red flags on inflation come against the backdrop of a comfortable outlook for economic growth, which stands above 7% for the current fiscal, going up to 7.5% in the first quarter of fiscal 2019-2020.

Alongside, the output gap (the gap between potential output and actual output) has almost closed, indicating that the economy is producing near its potential. This comfort left the MPC solely focused on inflation and inflation expectations as the issue to be managed.

One of the worries outlined by the MPC is the increase in the Minimum Support Price (MSP) for agri-produce, which could contribute to higher food inflation. This, along with high crude oil price, and coupled with volatility in the financial markets, would also adversely impact the outlook on inflation. An even more worrisome feature is household inflation expectations, which have risen sharply and have the potential to drive actual inflation outcome.

Another factor is the poor fiscal management at the Centre and in the states. As recent evidence suggests, fiscal slippages have been a rule rather than the exception. Such slippages are likely to negatively impact the inflation outlook, apart from the downsides like volatility in financial market and increased borrowing by governments, leading to “crowding out” of private investment.

Threat of three

Thus, there is a threat of inflation from three fronts: food inflation, fuel inflation and core inflation. When inflation persists and becomes all pervasive, its management becomes a priority through a policy repo rate hike. The gold standard of policy is to beat the beast before it can raise its head, because once it does, it will require far more beating to tame it.

Yet, it bears looking at how this rate increase will find its way over time into the rate at which the banks lend to customers. Normally, a change in policy repo rate works through the interest rate channel, moving from the shorter end of the market, that is the call money rate (overnight inter-bank money market rate) to the longer end of the market (the rates for 10-year bonds) and then to the bank lending rate, where the pinch is felt by the customer.

Evidence suggests that the increase in repo rate, with some lag, does impact the bank lending rate and discourage consumption demand. This could also impact investment. In other words, the repo rate hike and subsequent increase in bank lending rate while moving the economy to a “disinflationary glide path” calls for some sacrifice. This sacrifice comes in the form of lowering of economic growth.

However, the MPC’s outlook on economic growth stands at 7.5% in Q1 of FY20, which reflects an optimistic bias. The hope that inflation can be lowered without sacrificing growth is likely to be in vain.

One crucial aspect is the RBI’s stance on liquidity management, which continues with a neutral stance. This means, the RBI would work to keep liquidity in the system neither in deficit nor in surplus mode. But with two consecutive increases in the policy rate, adhering to a neutral stance may not be the best course of action. The system may require some accommodative stance as it adjusts to the tightening. In principle, the RBI remains committed to a neutral stance. The market has to therefore read and accordingly adjust cash management.

In sum, the decision by the MPC is the right step at the right time. It’ll help meet the legislative mandate of the monetary policy, which is “price stability, keeping in mind growth.”

(Pattnaik is a former Central banker and Rattanani is a journalist. Both are faculty members at SPJIMR)

(The Billion Press)