The MPC meets in the background of perhaps the largest decline in GDP in the country. Inflation is above RBI’s tolerance band of 6 per cent. The term of the current committee comes to an end in Sep’20, unless extended. What should the MPC do? Should it follow the conventional approach or take an unconventional view?
Keeping prices stable
The guiding principal of India’s monetary policy is the maintenance of price stability, while keeping in mind the objective of growth. Price stability is a necessary pre-condition to sustainable growth. With growth rates decreasing from a high of 8.2 per cent in the quarter ending Mar’18 to a low of 3.1 per cent in Mar’20, RBI reduced policy rates by 2.5 percentage points to support growth.
The policy easing cycle began in Feb’19, when inflation was close to 2 per cent. In the financial year ending Mar’19, CPI inflation was 3.4 per cent. The ambit of the amended RBI Act is to keep inflation at 4 per cent target for the period from August 5, 2016 to March 31, 2021 with a band of +/- 2 per cent. Notably, CPI inflation has averaged 4.1 per cent in the last four financial years as against 7.6 per cent during the previous four years (2013-16). Thus, the flexible inflation targeting framework has met its stated objective.
Since the 1970s, this is only the second time that in any five-year period India has restricted CPI inflation to such low levels. Prior to this, it was seen between 1999-00 and 2004-05. When the current framework was set up, it was felt that monetary policy would not be able to bring inflation down as CPI inflation had averaged more than 8 per cent in the 10 years prior to that (it has averaged 8.2 per cent since 1970s).The Government and RBI should take this as a successful case study of monetary and fiscal policy co-ordination.
The bigger question is what should be the mandate in the future, as current the MPC’s term comes to an end in Sep’20. In the current context, perhaps growth may also be added to the mandate of MPC as stated in the objective of monetary policy. A wider mandate will compel the MPC to explore different monetary policy tools to achieve its stated goal. Without a growth mandate, the task of MPC becomes difficult as CPI inflation at 6.1 per cent is above the tolerance band of 6 per cent even when GDP is likely to have contracted by 25 per cent in the quarter ending Jun’20.
The increase in retail inflation is driven by food inflation which rose to 9.2 per cent in the quarter ending Jun’20, from 6.7 per cent in 2019-20. The supply shock from the country wide lockdown drove food prices higher. Higher gold prices and increase in petroleum taxes also played a part. The demand shock will play out in the form of lower discretionary consumption, thus driving core inflation lower, led by housing in the coming months.
A mean reversion in food prices is inevitable as seen in the last five years when food inflation has increased by 3.6 per cent. This is quite favourable compared with an increase of 8.2 per cent over the last 50 years which should be seen in the context of food security and self-sufficiency. India is now a leading producer of cereals, milk and fruits and vegetables in the world. Thus, price-induced supply response of a large magnitude is not required.
The above backdrop, when juxtaposed with a sharp decline in GDP, opens up room for monetary easing. The MPC does not need to wait for inflation to come down before it cuts rates. A rate cut right now will ensure that interest rate transmission continues.
Apart from interest rates, RBI would have to decide on the loan moratorium, which is valid till August 31, 2020. This will have a bearing on financial stability. Data for Apr’20 shows as many as 55 per cent customers had opted for moratorium. Latest data on moratorium released by banks for Jun’20 shows large decline in moratorium availed by customers. This can be explained by continuous improvement in economic activity. For instance, electricity output, which was 75 per cent of pre-COVID levels in Apr’20 is now at 91 per cent of pre-COVID levels. Same is the case with E-way bills, which were at 16 per cent of pre-COVID levels in Apr’20 and are now at 75 per cent of pre-COVID levels.
Even so, economic activity has settled at a lower level than earlier which implies post-COVID cash flows for some sectors will not be enough to support pre-COVID borrowing. According to RBI’s baseline assessment, GNPA ratio of SCBs is estimated to increase to 12.5 per cent as of Mar’21 from 8.5 per cent as of Mar’20. While sectors such as healthcare, consumer goods, telecom and IT services have weathered the pandemic and in some cases benefited as well, commercial real estate, hospitality and airlines have been hit the hardest. Hence, instead of extending the moratorium it may be prudent to allow one-time restructuring for select borrowers impacted by pandemic.
Another issue that RBI will have to address is the steep yield curve. At present, the different between 3-month and 10-Year yield is more than 250bps. Such a steep yield curve (325bps) was last seen in Jun’09. Given gross borrowing of Rs 12 lakh crore, markets do expect RBI to buy government bonds. RBI’s communication on its bond purchase policy will be helpful as seen in the case of other global central banks.
In a nutshell, RBI faces a few dilemmas in this monetary policy. A 25 bps rate cut now will aid in transmission and support growth when RBI is near the end of its easing cycle. A one-time restructuring will ensure financial stability and a communication on bond purchase will give the right signal to bond markets.(The writer is Chief Economist, Bank of Baroda)