Growth Concerns, Fear Of Financial Froth Split Monetary Policy Committee

Concerns about weaker growth against the backdrop of low inflation prompted five of six members of India’s monetary policy committee (MPC) to vote for a rate cut, show minutes of the committee’s August meeting released on Wednesday. The sixth member, Reserve Bank of India executive director Michael Patra, voted for a status quo on rates citing the likelyhood of a rise in inflation and a financial environment which is “bubbly and frothy.”

In a split vote, the MPC voted to reduce the benchmark repo rate by 25 basis points to 6 percent on August 2. Four members voted for a 25 basis point cut, one voted for a 50 basis point cut and one voted for a status.

Among the four who favoured a quarter percentage point cut were RBI governor Urjit Patel and deputy governor Viral Acharya. Both cited concerns on growth as a reason for backing a rate cut.

Patel noted that while the RBI has retained its gross value added (GVA) growth outlook at 7.3 percent for 2017-18, downside risks have emerged for both industry and services. That, along with continued signs of disinflation, leave room for a rate cut, argued Patel.

The mid-year economic survey released by the government’s Department of Economic Affairs last week also cited risks to the growth forecast of 6.5-7.5 percent for the current fiscal. Meeting the upper end of that band would be challenging, said the survey.

Economic momentum had started slipping last fiscal with fourth quarter growth sliding to 6.1 percent. High frequency indicators like the Index of Industrial Production (IIP) have also weakened with industrial output contracting 0.1 percent in June.

Acharya, in his comments, noted that this weakness in growth would lead to a negative output gap.

The monetary policy committee’s external members Chetan Ghate and Pami Dua cited similar reasons for backing a 25-basis-point rate cut.

Both Patel and Acharya, however, voted to maintain the ‘neutral’ stance as they awaited more data to understand whether down-drift in inflation is structural in nature.

Acharya also reiterated his view that slightly higher real rates are justified at a time when a balancesheet clean-up is underway. In the absence of an efficient transmission mechanism, lower rates could “backfire” and lead to misallocation of investments which, in turn, could fuel asset price inflation.

The Split Within The RBI

Breaking rank with his colleagues, Patra argued that a status quo on rates is the appropriate way to go at a time when official forecasts suggest that growth will strengthen and inflation will pick up over the course of the year.

Patra didn’t stop at that and raised concerns about the financial environment which he described as “bubbly and frothy.” Patra’s comment, while not the official view of the RBI, is the first such red flag raised by a senior central bank official.

Patra also noted that inflation in India had come down from above 8 percent to 5 percent and below, partly due to ‘good luck’. He cited the collapse of crude prices, the new consumer price index, demonetisation and favourable supply shocks as factors that had helped bring down inflation.

“Now that we are in a formal inflation targeting framework, why not strive to achieve the mandated target with good policy?,” asked Patra.

‘A Rule-Based Policy Regime’

External member Ravindra Dholakia called for ‘at least’ a 50-basis-point rate cut for the second consecutive meeting. According to Dholakia, his forecasts suggest that CPI inflation will be 50 basis points lower than the RBI’s forecast. The central bank expects inflation to remain between 2.5-3.5 percent in the first half of the year and move up towards 4.5 percent in the second half.

Dholakia added that his research shows that core inflation tends to drift towards headline inflation over a period of time. This suggests that headline inflation will settle close to the RBI’s target of 4 percent, based on Dholakia’s assessment.

Meantime, growth remains weak as is evident from low capacity utilisation and potential output is expected to inch higher due to reforms such as the implementation of the Goods and Services Tax (GST). Dholakia said this is leading to an “expanding negative output gap” which needs “immediate aggressive policy action to correct it.”

Dholakia also chastised the RBI for not following a rule-based policy approach, which, he said, was the idea behind moving towards an inflation targeting framework.