An Indian Monetary Policy-Maker’s Mind

The Monetary Policy Committee (MPC) was set-up to decide on India’s policy rates to find a balance between growth and inflation. In its last meeting on 6-7 June, quite ironically, the MPC did not reduce policy rates even in the face of historically low inflation rates. This piece will analyse the various factors the MPC probably kept in mind while taking this decision, in order to demonstrate the kind of decision-making that goes into our monetary policy.

The MPC uses a variety of policy rates to control inflation and money supply. Of primary interest is the Repo Rate —6.25% right now— that has the greatest bearing on maintaining inflation within the target of 4% +/- 2%. ‘Inflation Targeting’ is a system where the finance ministry sets an inflation target for the RBI. This helps coordinate fiscal and monetary policies, but more importantly prevents the government from influencing monetary policy to spur short term growth at the cost of inflation for political gains, once a fixed target has been set. Despite this, our headline inflation rate (CPI) has remained around the lower ends of this range (2.18% at present) which makes one feel that the economy can take a rate cut to spur growth.

While we analyse the various factors at play we need to remember two things:

  1. A rate change affects inflation after a lag of a few quarters
  2. A rate change only alters the demand-pull inflation, doing nothing for the cost-push inflation.

In the light of this, we can examine various factors that should be considered before we critique the MPC’s policy stance.

The CPI’s major component is food inflation which in turn depends upon food supply in our country. The demand for food has always been fairly constant, but the supply is subject to great volatility due to the dependence of produce on climatic conditions. At present, farm prices are extremely depressed, which also lead to large scale farmer protests across the country in June. This is a major reason why our CPI is low. In fact, our core inflation, which looks at inflation sans food inflation has been fairly sticky at around 4-5%. The core-inflation is a better metric of demand-pull inflation and is the more relevant indicator to consider for policy rate changes. Even the little depression in this core inflation is arguably from the impact of demonetisation which eroded liquidity and thereby demand. Now, as said before, the rates cannot impact cost-push inflation and we don’t even know if farm prices will remain depressed after two quarters. Therefore, the low CPI numbers are illusionary to this extent, and a rate cut is not going to improve things.

Let’s consider investments:

First, If we look at the components of output/income, Y= C+I+G+(E-M). E-M or Indian net exports are depressed due to a global slowdown and C or consumption demand is depressed due to demonetisation. Both of these are issues that cannot be resolved in the short run. An economy cannot depend on G or government expenditure for long, and in fact that itself would lead to further inflation. Therefore, it is very important to help strengthen the one sector that we still can —I or private investments. But, India has a very depressed private investment environment as of now with private investments fairing poorly quarter after quarter. This is largely due to the high leverage in different industries— also the cause of the NPA problem. Lowering interest rates to encourage private investments is not going to work as corporates cannot strain their leveraged balance sheets further, which in fact is the cause of this very problem. Therefore, India needs to look to foreign investments to help improve its investment environment.

Second, with the US gradually hiking its interest rates, FIIs are fleeing emerging economies in the search of safe havens or US bonds. Even if India still has a higher real interest rate, discounting this rate with the currency, liquidity and business risks that every emerging economy faces, what we offer comes very close to what the US offers. Another way to look at it is that we need to offer that higher real interest rate as premium for the higher risk, investors investing in India undertake. Further, investors need to hedge against the liquidity risk because the rupee is not very marketable in the forex market through cross-currency swaps or forwards which again add to their costs, reducing the effective interest rate. Lastly, a hike in the US interest rates, more than the current position, is a signal that the US economy is improving and that an investor should pay attention.

Third, lowering our interest rates will increase our money supply which will depreciate our currency. Therefore, an FII who is already invested in India will want to pull his money out as soon as possible because his earnings in India will fetch him fewer dollars.

In this entire scenario, it becomes important for India to provide a competitive rate of interest to these FIIs.

The incoming GST is expected to bring in inflationary pressures primarily from the increased service tax rate of 15%/18% from the present 14%. Considering about 40% of India’s income is generated from the service sector, increasing the tax rate by 7.14%/28.56% will create an impact. The manufacturing sector may not be affected as a large proportion of the CPI sector is in the exempt or 5% rate bracket. Again, these inflationary pressures will be in focus after a few quarters, which is the period that will be affected by a rate cut in the current period.

While oil price movements are still very uncertain, it is now certain that the OPEC and the other major oil producers have come to grips with the fact that they cannot function any longer at the current oil prices. The last meet at Vienna had the parties agree to extend a 1.8m barrels a day supply cut to the first quarter of 2018. While it cannot be said if the parties will honour their commitments, or if the US Shale Producers will again flood the market, it is certain that oil prices are going to be uncertain. Any increase in oil prices will spike CPI and that inflationary risk. Oil powers machinery, generates electricity and runs transport vehicles. An increase in the prices of these components will augment prices pervasively.

There are many other factors at play that need to be gauged by the monetary authority. The minutes of every MPC meeting is released on the RBI website after each of its bi-monthly meetings –Second Bi-monthly Monetary Policy Statement, 2017-18 -which can help you further understand how our monetary policy makers think!


A Note On The MPC:

The MPC is a 6 member committee that sets India’s monetary policy through a one-person, one-vote system (The governor has a casting vote in case of a tie). The Committee has 3 members nominated by the government and 3 from the RBI (including the Governor). The MPC replaced the older system where a Technical Advisory Committee would make non-binding recommendations and the Governor took the final call.

The reason why the MPC is a change for the better is that it translates the opinions and knowledge of six, representing both the government and the RBI, instead of the subjectivity of just one person. If that one Governor is great, the erstwhile system would surely be more efficient, but a system cannot leave monetary policy at the subjectivity and competency of one individual. This is analogous to why democracies are better than dictatorships, even though a good dictator can be much more efficient than a democracy.



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