Has inflation cooled enough to lower rates? Experts debate

The governor's stated goal is to bring inflation to 6 percent by January 2016. Our poll indicated that economists see inflation decline to 6.2 percent at best by January 2016; only 20 percent saw inflation below 6 percent in January 2016. Hence there are no huge rate cut expectations: 70 percent of those polled see a maximum of 50 basis cut by January 2016. 10 percent saw only a 25 basis point cut by next January and only 20 percent saw a 75 bps cut in repo rates by January 2016.

Now for a more threadbare analysis of whether and when the Reserve Bank can cut interest rates.

One of the most immediate factors that has enthused the market into expecting a rate cut is the over 20 percent fall in crude oil prices in the last 4-5 months. But Sonal Varma, economist at Nomura India, thinks everyone is overplaying the role of commodity price fall on CPI considering it is largely a non-tradable basket because it has food and services in it. Hence the impact is rather low.

"Our estimates are that every USD 10 fall in oil leads to may be about 20 bps moderation in CPI inflation," she adds.

Varma adds that rural wages and nominal rural wages per annum in the last 2-3 years has fallen to single digits, somewhere near 5-10 from 15-20 percent per annum and that is what is driving down the cost of production for these non-tradables and that is the reason why CPI inflation is coming down, not so much commodity prices.

Sajjid Chinoy, JP Morgan economist and member of the Urjit Patel Committee on monetary policy framework too is not convinced that the recent cooling off in inflation is permanent. He says there is a seasonal drop off at vegetable prices but one cannot with certainty that we have done everything on the ground to ensure that there is no spike in vegetable prices three or six months from now.

According to Chinoy, what we are seeing are tactical disinflationary forces for food. But he is unsure that one can say structurally next year food inflation will gap down from a historical average of 9 percent to 5-6 percent. “It is too early to conclude that and that is why the Central Bank will have to be cautious,” he adds.

Also, Dr C Rangarajan, former Reserve Bank governor and India's original inflation warrior says the impact of deficient monsoon this year has not been as severe as it was originally thought of and that is one of the reasons why some of the prices even vegetable prices have not been rising as fast as one had expected.

Rangarajan sees inflation staying at a much lower level. He says: “There is no insurance against rise in vegetable prices six months from now but my own feeling is given the fact that MSP is not being raised sharply, given the fact that more liberal attitude towards the release of food stocks is being contemplated, I would expect the food inflation to come down, stay at a much lower level.”

Below is the verbatim transcript of Dr Rangarajan, Sajjid Chinoy and Sonal Varma's interview with Latha Venkatesh on CNBC-TV18.

Latha: Obviously the most immediate factor that has enthused markets into expecting a rate cut has been this seminal fall in crude prices. It is into bear market terrain - over 20 percent fall in the last four-five months. What is the impact of a 10 percent fall in crude prices on the consumer price index (CPI) itself?

Varma: I think we are overplaying the role of commodity price fall on CPI inflation. Wholesale price index (WPI) inflation of course largely being a commodity basket gets impacted but the impact on CPI inflation, which is largely a non-tradable basket because it has food where we are largely self-sufficient and services, the impact is quite low. Our estimates are that every USD 10 fall in oil leads to may be about 20 bps moderation in CPI inflation.

The 10 percent rate of fuel and light in CPI has liquefied petroleum gas (LPG) and electricity where prices are still subsidised. So, it is not crude, the more important variable which we have been tracking is rural wages and nominal rural wages on our rough estimates have fallen to single digits now somewhere in 5-10 percent range from 15-20 percent per annum and that is what is driving down the cost of production for these non-tradables and I think that is primarily the reason why CPI inflation is coming down, not so much commodity prices.

Latha: We have definitely seen the CPI numbers surprising on the downside. I remember in August we were all talking about 7.8 percent and finally we got closer to 7.3 percent. Even for the month of September, our guesses were more towards 7 percent and we got 6.46 percent. So clearly, as Sonal Varma pointed out, rural wages and food inflation have surprised on the downside, how are you assessing food inflation going forward? Do you think we have got out of that double digit inflation for a longish bit?

Chinoy: I think there are several factors at play. One is you have got a seasonal drop off at vegetable prices but you cannot with a degree of certainty say that we have done everything on the ground to ensure that there is no spike in vegetable prices three months from now or six months from now.

The second to their credit, the government has been far more pro-active in releasing stocks of rice and wheat. Therefore what you are seeing is cereals inflation has come off quite sharply. So the combination of cereals inflation moderating, vegetable prices coming down seasonally, global food prices which have some impact on oil seeds, pulses, sugar been benign, all of these factors have come together.

But let me conclude by saying, we have had 9 percent food inflation for the last 10 years and one cannot, with a degree of certainty, say that structural food inflation has gone away completely. What we are seeing are tactical disinflationary forces for food but I am not sure that we can say structurally next year food inflation will gap down from a historical average of 9 percent to 5-6 percent. It is too early to conclude that and that is why the Central Bank will have to be cautious.

Latha: What is your sense? You saw four-five years of inactivity in terms of offloading of FCI food and intervention in the food market. Now do you think things are picking up much better and as Sajjid Chinoy said, there is this perfect storm global food prices also falling and domestic MSP and rural wages also falling?

Rangarajan: I think one of these structural factors which has been contributing to the upward pressure on food prices has been the MSP except for the last two years. If you look at the policy decisions earlier, you have seen fairly sharp increases in MSP. That has contributed to the upward pressure in cereal prices. Therefore, that is coming down now and therefore that is in some way a structural change. There are other structural changes, which have been emphasized but this also should be treated as the structural change that we are currently witnessed.

Apparently the impact of even the deficient monsoon this year has not been as severe as it was originally thought of and that is one of the reasons why some of the prices even vegetable prices have not been rising as fast as one had expected. Certainly there is no insurance against the rise in vegetable prices six months from now but my own feeling is given the fact that MSP is not being raised sharply, given the fact that more liberal attitude towards the release of food stocks is being contemplated, I would expect the food inflation to come down, stay at a much lower level.

Latha: Where do you see CPI to March 2015 and March 2016? I know it is a tough question that far off into the future.

Varma: I think first of all, the underlying trend in inflation based on the numbers we have got on September suggest that the underlying trend is already between 6 percent and 6.5 percent on CPI. So the starting point is important to note because 6 percent obviously is the intermediary target for January 2016, but we are already almost there in the end of 2014. We have been positively surprised by the momentum in disinflation in the last two-three months and I think a combination of lower rural wages and lower MSPs is contributing to this decline.

Fundamental factors such as continued low MSPs into next year output gap, which will close but will close at a slower pace, real interest rates are clearly turning positive, a more proactive government decision-making in this environment and of course lower global commodity prices. In this environment, fundamentally inflation should be under check while there can be volatility because of weather distortions, I think the trend should be one of low inflation, that is our fundamental view. In terms of exact numbers, March 2015 inflation is roughly tracking about 6.5 percent and probably slightly under 6 percent by early 2016. Of course these are the tracking estimates, which can change but like I said, we have been surprised positively by the pace of disinflation in the last two-three months.

Latha: What would your numbers be?

Chinoy: Very similar. We are still looking at a number of about 6.5 percent or so by next March and I take the Central Bank at face value, they will do whatever it takes to keep it to 6 percent the following year.

I will just make one quick point, we have spoken a lot about food inflation but the fall in core inflation has been as dramatic. It was 8 percent throughout last year. The year-on-year (Y-o-Y) number today is 5.8 percent. If you look at the quarterly annualized momentum, it is below 5 percent. That in part is because growth impulses have been quite weak. So next year it is not fair to look at today’s core momentum and project in a linear fashion because to the extent that everyone is expecting some pick up in growth in 2015-2016, I think that will mean that there will be some pricing power back. So I think you should expect next year, even food inflation remains contained, core inflation could tick back up in the second half of next year not withstanding that, we are expecting 6.5 or thereabouts by March of 2015.

Q: Now for the more philosophical academic question. How should a central banker who gets 6.5 percent in March 2015 react if his goal is 6 percent in 2016 and maybe 4 percent in 2015. Should he actually relent and cut a little because overnight rates are at 8 percent. So should he relent by March or April or even February knowing fully well that at least we have come to 6.5, so some relief should be given. How should the central bank react?

Rangarajan: The overall environment as far as the price situation is concerned is moving towards a situation in which an easing of policy is possible. The question is the timing. I do believe that by March 2015 even retail inflation would be close to 6 percent, it could be even less by 6.5 percent. The factors that we need to take into account are the lower MSP, other world commodity prices, crude oil coming down. So all of this will have a favourable impact and therefore I do expect the prices to remain between 6.5 percent by 2015 yearly.

Therefore given that fact I would say that the easing of the policy can start once one more data point on inflation becomes available because we do know now retail inflation is coming down. Now we need one more data point to see yes, the tendency that we have noted in the last few months is confirmed. Once that really confirms the situation the prices are coming down the monetary authority can really think in terms of easing.

Q: In November we are even going to get a sub five number because of a very big base effect but the reserve bank’s fan chart itself indicates that they expect it to jump back towards 7 percent by the time we come to January. Maybe with some special circumstances it won’t go to 7, it may still go to 6.5. So, is one more data enough or should the governor have to wait even for the next season, next kharif before he cuts rates just in case what Sajjid was referring to that the age old 9 percent food inflation reasserts itself. Do you still say that he can cut by say, he gets a policy option in February and again in April?

Rangarajan: There is some reassurance that the food inflation is moving in the right direction. We have already discussed what are the favourable factors that are operating on it and the world commodity prices are coming down. Therefore when you look at the next data point we will look at it not simply in terms of the headline inflation behaviour but also in terms of the base effect and so on and if there is sufficient belief or if there is sufficient reason to think that the trend that we are noticing is really decisive then an action can be taken.

Q: So you are saying even December he can act or you would say that he can act in February which is the next policy?

Rangarajan: Definitely in February but December would be dicey but it all depends on the kind of data that we get regarding next month.

Q: The Reserve Bank’s stated view is that it wants inflation at 6 percent by January 2016 and their ultimate comfort zone is to get it to 4 percent given that should he hurry with a rate cut as early as February and how much should he follow it up with. Should he remain very wary till he sees that 4 percent mark?

Rangarajan: Ultimately 4 percent is the ideal number. We spoke about it in the mid 1980s, the Chakravarty Committee of which I was a member suggested the 4 percent as the appropriate rate but the whole thing is that we have to track it in terms of the direction in which it is moving. Now if you are convinced that yes, there is enough ground to believe that the prices are moving in the right direction some easing can still be done. If one had to wait till it actually reaches 4 that will be too late. That means that one is really not giving any credence to the direction in which it is moving. Therefore one cannot do that or doing that doesn’t require much forecasting powers or doesn’t require much ability on the part of the central bank. The central bank should be in a position to anticipate and take action.

Q: What do you think the reserve bank should do, when should the first cut be and how many cuts, say, in the next one year or 18 months?

Chinoy: Purely it is a prescriptive comment. They should be very cautious. The point is that you want to not only bring inflation down to 6 percent but to keep it at 6 percent or below over the course of the entire business cycle and I am not sure we can. Undoubtedly there have been some structural changes in MSPs and releasing rice and wheat stocks but apart from those I am not sure we can with a degree of confidence say that disinflationary forces that have existed so far are going to sustain. When growth does pick up to 5.5 or 6 percent where will core inflation be. How confident can be that global oil prices are going to stay at these levels and not reaccelerate when US growth picks up next year.

Faced with those uncertainties when you are one year ahead of your target I would argue given the historical legacy there is enough uncertainty on inflation for the central bank to be very cautious. I will make two final points. We have done some econometric work to suggest that inflation expectations which are very sticky are adaptive in nature in India and not rational. They are backward looking, not forward looking. So in that environment if one of your goals is to bring inflation expectations down what you want is to push inflation down as much as possible. It is only when you have consistent positive surprises on inflation with households actually become to become believers.

So given that very sluggish response of expectations the central bank should be very cautious. We have also sort of estimated this is speculative in nature that if potential growth is about 6.5 percent where should neutral policy rate be and our sense is it is somewhere between 7.5 to 7.75 because if inflation settles down at 6 percent that gives you real policy rates of about 1.5 or 1.75 percent which we think is sort of neutral equilibrium rates. Remember in mid 2000s real policy rates were above 2.5 percent.

So given all of these factors my sense is I would prescribe no rate cut until the next monsoon is over and we have much more clarity on whether food inflation is gaping down structurally and we know what the growth cycle is and core inflation is and B, even when the rate cycle easing starts I don’t see more than 25 or 50 basis points to ensure that real rates remain positive and healthy to get the financial re-intimidation of savings.

Q: When is your first cut expectation and how many in the next 18 months?

Varma: Our base case is actually for the RBI to stay on hold through 2015 and we are pencilling in a cut only in early 2016. Given the moderation in inflation there is some probability that we would assign two cuts in second half. But two things to keep in mind; one like you said the target is 4 not 6 and to keep it in the 4-6 band in an environment where output gap will be closing and second also we have to take into account the Fed rate hike cycle next year and what that is going to do the capital flows into emerging markets.

So, both the factors have to be taken into account. Surely the space for rate cuts is opening up but RBI is likely to be and actually should be cautious given we are coming from a period of very high inflation. We seem to be winning the battle but the last thing we would want is actually flip-flopping in policy making.