Limited Room For Monetary Policy Accommodation
Like the budget, the forthcoming monetary policy committee review by the Reserve Bank of India comes squarely in between a massive economic, social and behavioural experiment – demonetisation; and only a few months prior to another transformative change – the switch to the goods and services tax.
The budget was correct in choosing to remain mostly on the path of fiscal consolidation, resisting the allure of using the government’s balance sheet to stimulate the economy. The RBI Governor has also repeatedly emphasised the need for fiscal prudence and advised against an unwarranted buildup of debt. Is this fiscal prudence not a justification for a more aggressive monetary policy stimulus? Wage growth is unlikely to overheat in the near future, even with the hike in minimum wages. Capacity utilisation remains low, inhibiting corporate pricing power. This article argues that hard-won monetary, inflation and currency stability are too important to risk with an inopportune move at this juncture.
Global Uncertainty
First, as is widely known, the world will go through a period of extended uncertainty, with political shadows looming over unsettled economics. Tightening inventories, short covering by traders and occasional supply disruptions have driven metals prices higher sharply, and kept them elevated. Excess inventories have been gradually drawn down and capacities have tightened. Interest rates across developed markets have gone up.
As global funds seek to better understand the evolving trade architecture, there have been significant capital outflows from emerging markets, creating currency market turbulence.
Emerging markets too are beginning to gradually tighten, as China’s repo rate hike last week indicated.
Surplus Liquidity
Second, 'financial conditions' in India were already significantly loose since the change in RBI’s liquidity framework in April 2016 with surplus liquidity following the RBI's open market operation driven liquidity injection. These have eased further since the demonetisation exercise to levels rarely seen. The banking system is still surplus in liquidity to the extent of about Rs 5 lakh crore. This is unlikely to deplete anytime soon, with weak credit growth seen to be persisting. Market interest rates are at 6–7 year lows, and even transmission to bank lending rates has intensified after the infusion of massive liquidity.
In one sense, liquidity and soft credit growth have now become virtual automatic stabilisers for interest rates.
Only when economic - and hence credit - growth revives will lending rates begin to go up.
Shorter-Lived Demonetisation Impact
Third, the hit of demonetisation and global uncertainty on India’s growth remains uncertain. Although there will certainly have been an impact of the extraction of currency, it appears that for larger and mid-sized corporates, the impact might be shorter-lived than earlier feared. The latest manufacturing and service Purchasing Managers Indicators (PMIs) show sharp upticks in January, after dropping in November and December.
Indications are that growth will have come off in the second half of FY17. This is also indicated in the revised GDP growth numbers that are assumed in the FY18 budget.
The Risks To Inflation
Inflation, barring sharp exogenous shocks, is unlikely to move up rapidly, given the extent of persisting excess capacity in the economy. The central government has followed very prudent policies on the minimum support price. Rural wage growth remains muted.
But there are indeed risks to this view. Depending on one’s point of view, a heartening feature of the budget was a lack of mention on the implementation of allowances - particularly the house rent allowance - as recommended by the Seventh Central Pay Commission. This certainly reinforces the picture of fiscal stability and restrained deficits. However, the progressive diffusion of salary increases to state government employees, as has already happened in a few states, raises the risks of a surge in aggregate demand. Also, although household inflation expectations have come off a bit since October 2016, they still remain too sticky for heaving a sigh of relief.
How GST Will Play On Inflation
The next major change in the structure of economic activity is likely to be the changeover of indirect taxes to GST. As we now know, this is not likely to formally shift the inflation trajectory higher, given the importance of food and some other commodities - which are excluded from the ambit of GST - in the composition of the consumer price index basket.
But the perceived impact of those services which are included in GST might shift household inflation expectations, which unfortunately underlies a dreaded wage-price spiral. In conjunction with the move of the informal economy to the formal segment, this might also serve to push up costs, contributing indirectly to inflation.
If rains are disruptive again, this will add to food supply problems.
The critical issue at this stage of the rate cycle is the extent of room for further repo rate cuts. Prior RBI guidance on estimates of the neutral rate pegged it at an equivalent of the real 1-year ahead T-bill rate, around 1.5–2.0 percent. However, in light of the global reduction in neutral rates in 2015 and early 2016, this was discounted to 1.25 percent. How transitory these predictions are is shown by a rapid reversal of these conditions. Most central banks are now beginning to act on, or at least start discussions on tapering their loose monetary policies. It probably is best at this point in time to understand the transmission links to Indian markets better before deciding on a rate cut.
Saugata Bhattacharya is a senior vice president and the chief economist at Axis Bank. His views here are personal.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.