Interview | See terminal repo rate at 6% before MPC becomes data-dependent, says former committee member Mridul Saggar

One basis point is one-hundredth of a percentage point.

High inflation and a low repo rate – the policy rate was at an all-time low of 4 percent for nearly two years – mean the real policy rate is sharply negative, a fact noted by two MPC members in the minutes of the May 4 meeting, when the committee acted outside of its schedule in anticipation of an alarming April inflation print.

Inflation surged to 7.79 percent in April– the highest since May 2014 and 84 basis points higher than the March number of 6.95 percent – showed data released on May 12 by the government.

According to Saggar, the number of commodities in the Consumer Price Index (CPI) basket whose prices increased month-on-month in April was the highest since August 2014.

Although Saggar said there is still no concrete evidence that India is facing strong demand-side inflation, indications of some generalisation of inflation are visible.

"We are now starting to see corporate margins getting a bit squeezed, so the pass-through to retail inflation could rise. In this milieu, monetary policy needs to be tightened without going overboard," Saggar said.

"So, it is quite possible that a terminal repo rate of 6-6.5 percent could do the trick, but I would hesitate to put out a hard number on that at this juncture and future decisions should remain data-dependent," he added.

Term of transition

Saggar's 21-month tenure on the MPC was of great asymmetry. In the meeting prior to him joining the committee in August 2020, the repo rate was cut by 40 basis points to 4 percent. In the first meeting after his exit from the MPC, the repo rate was increased by 40 basis points.

The 11 meetings that took place between these two rate actions did not see any change in the policy rate.

"To be honest, I confess that I had seriously considered voting for a rate hike at the next policy just when the May inflation data was released after the June 2021 policy," said Saggar, who last week took charge as the Investor Education and Protection Fund Authority Chair Professor at the National Council of Applied Economic Research.

"But the June CPI numbers that came out in July turned out to be antithetical to the previous month's inflation trends. There were some other occasions too. As a policymaker, I avoided reacting to one month's data as it could be an aberration and in hindsight, that was right as premature tightening could have led to a choking of recovery," he explained.

CPI inflation jumped to 6.30 percent in May 2021 from 4.23 percent the previous month before edging down to 6.26 percent in June 2021 and further to 5.59 percent in July 2021.

While the high inflation prints early in the pandemic were accompanied by a large output gap and disruptions caused by new COVID-19 waves, Saggar now sees "a very different characteristic of inflation" that is not transitory.

At the same time, output has normalised, although the possibility of growth slowing down is apparent.

"That sets a very difficult course for monetary policy because it will have to adjust liquidity and interest rates but not so much as to sacrifice growth beyond a point. We can't afford for growth to collapse. So monetary policy will have to be deft."

No recovering lost output

According to Saggar, a certain "wishful thinking" around growth needs to be dispelled.

"There is some wishful thinking when it comes to growth because most people think we should recoup all lost output and attain a GDP level which would have existed if there was no pandemic," Sagar said.

"This is a fallacy in thinking because with scarring, the economy's potential output would have reduced. Therefore, if monetary policy is aligned to this wishful thinking, then one would tend to make a policy mistake," he added.

According to the RBI's report on currency and finance for FY22, it could take nearly 15 years for the Indian economy to make up for the output it lost to the coronavirus pandemic.

Higher growth is widely accepted as requiring focus on capital expenditure, something the Indian government has done since the start of the pandemic in the hope of crowding in private investment.

But with demand being weak and capacity utilisation below 75 percent, questions have been raised as to how long public capex will have to prop up the economy.

"A mega capex cycle is still difficult till the pandemic and geopolitical uncertainties go away," Saggar said.

Even so, he sees some proverbial green shoots, including a 15.8 percent increase in gross fixed capital formation in FY22, according to the latest GDP data.

Order inflows in the capital goods industry have picked up, with production and imports of capital goods pointing to a "short-cycle capex".

"What matters ahead is the way the government's policies are structured to encourage private investment and revive animal spirits. I would like to highlight the impressive work that was done by the National Highways Authority of India during FY21 when capex elsewhere had collapsed due to the pandemic," Saggar said.

A key consideration should also be improving productivity growth, which has been sluggish in several countries, including India.

Fiscal downsizing

Along with the policy rate, the government's cost of borrowing has also been low since the pandemic began.

While government bond yields have risen sharply in the past few months, the preceding year-and-a-half or so saw the RBI use numerous tools to limit a rise in yields – including outright purchases and statements labelling the yield curve a public good – which Saggar said was perceived as "de facto soft yield curve control".

But even the RBI can't keep interest rates low and maintain macroeconomic stability if the government's borrowing programme expands year after year.

What is needed is for the government to "downsize itself structurally", Saggar said.

While certain allowances can be made for the government given the pandemic and legacy issues it confronted, it has to create counter-cyclical fiscal space going forward.

Citing the example of the euro area, Saggar argued that "good times" must be used productively by governments to create the financial room for events that may require them to spend heavily.

"India too expanded gross debt-to-GDP ratio by 15 percent in 2020. But as it had not created fiscal space during 2011-19 when its debt was on an increasing path, it left little further scope," Saggar said.

"In the pandemic, the government took more load on itself, essentially because private sector animal spirits died down. Otherwise, growth would have plummeted. With already high debt, the last thing India can afford is for growth trajectory to be endemically slower," he added.