The decision to maintain rates is consistent with what the monetary policy committee has been doing so far since the move to the flexible inflation-targeting framework.
At first blush, one would think that the Reserve Bank of India's rate decision and monetary policy stance is inconsistent with data. Consider this: October inflation is 3.3 percent; RBI has cut its inflation forecast for the second half of the financial year to 2.7-3.2 percent from 3.9-4.5 percent earlier. Yet, it has neither cut interest rates nor dialled down the policy stance to neutral.
The decision to maintain rates is consistent with what the monetary policy committee has been doing so far since the move to the flexible inflation- targeting framework. RBI has consistently conveyed the message that it wants to keep consumer price inflation at 4 percent over the medium term.
Indeed, defending the rate hike decision in August, governor Urjit Patel said: "The main reason for changing the policy rate is to ensure that on a durable basis we come to and maintain the 4 percent target. And we've been away from the 4 percent target for several months now."
Sure, inflation is down and inflation projections for the second half of the fiscal are down. But as deputy governor Viral Acharya pointed out, the projection for inflation one year ahead (essentially the first half of fiscal 2019-20) is 3.8-4.2 percent, which is still more or less around the 4 percent target. Indeed, RBI's inflation expectations survey points to a 40 basis point reduction in the three-month ahead horizon, but remain unchanged for a year ahead.
That the 4 percent target is sacrosanct can be seen from the fact that RBI prefers to err on the side of caution when it comes to rate decisions. In the current policy statement as well, there was a predictable laundry list of upside risks to inflation.
For one, the rate-setting panel is worried that there could be a sudden reversal in food prices, especially perishable stuff like fruit and vegetables. Second, it is waiting for the effect of higher minimum support prices (MSPs) for crops to play out. Third, the governor pointed out that while crude oil prices are down, they are still very volatile as are financial markets. Sticky inflation expectations are another reason. Lastly, the panel is also worried about fiscal slippage at both the central and state levels.
After enumerating these risks, the governor did offer a ray of hope by saying that if these risks don’t materialise, there is the “possibility of space opening up” for further actions -- like a reversal in stance or a rate cut. But looking at the list of risk factors, one thing is clear.
The RBI has essentially said that any possibility of inflation remaining at these levels will depend on how much the government sticks to the path of fiscal prudence. Note that volatility in crude oil and financial markets are nothing new. There is also no particular reason why there should be a reversal in food prices.
But the fears of the fiscal deficit spiralling out of control in an election year, pushing up inflation, heightening market volatility and crowding out private investment are very real. Remember, that the fiscal deficit for April-October is already close to 105 percent of the budget estimate. If the government reckons to play a significant part in boosting growth – as much as it did in the September quarter – then there is a clear danger of overshooting the target.
As the monetary policy statement notes, "The time is apposite to further strengthen domestic macroeconomic fundamentals. In this context, fiscal discipline is critical to create space for and crowd in private investment activity."Ultimately, an inflation-focused framework is only successful if there is no fiscal profligacy. With all other factors more or less favourable, this will remain key as we go into the next policy, the last in the current fiscal.