Monetary policy communication is an art, not a science, hence there is no single correct style or content. Thus, central banks’ monetary policy communication can understandably be self-serving. After all, they are privy to the decision about their action, say to raise policy rates, and can tailor the policy statement accordingly. However, the policy guidance should at least be in sync with the macroeconomic reality and the policy action announced. But the Reserve Bank of India’s (RBI’s) mid-year review of monetary policy on October 25, in which it increased the repo rate by 25 basis points and signalled a pause, reveals signs of a reluctant compromise. Further, it confuses more than it clarifies at this critical juncture in macromanagement.
There are three key parts of the RBI’s monetary policy: policy action, justification for the action, and guidance. The RBI’s continuing concerns over high inflation and inflationary expectations, and the sticky and generalised character of inflation, justified another rate hike, in its assessment that is not shared by all. However, less clear is the reason for the RBI to be willing to now see through the widely-anticipated high wholesale price index (WPI)-based inflation for October and November to signal a pause in December, but not hold fire in October for the same reason. Indeed, if it is willing to live with elevated inflation for two more months, would another month have created big problems, especially if it is now suddenly worried about growth?
Frankly, the unique – but unnecessary style of – time-bound dovish guidance is at odds with the rate hike and is a 180-degree turnaround from the singularly hawkish tone, guidance and comments that RBI officials have been feeding us. Further, the RBI has been slow in acknowledging and acting on the palpable signs of moderation in growth. Indeed, its new-found focus on the deceleration in investment activity should have emerged some months earlier.
An embarrassing part of the policy statement is how the RBI assesses the trend of seasonally-adjusted WPI inflation data. It has now concluded that this indicates moderation, consistent with its inflation projection. Just some weeks ago, in the September policy statement, it had guided, “The inflation momentum, reflected in the de-seasonalised sequential monthly data, persists.” It is hard to imagine that the dramatic difference between the two views is owing mainly to just one month’s provisional WPI data.
The RBI is essentially riding on a strong base effect for the year-on-year (YoY) WPI inflation trajectory from December onwards. Indeed, it is unclear what the RBI will do if the sequential pace of increase in WPI picks up, because of, say, upward revisions in administrative fuel prices, but the YoY trend is still softening.
The bottom line is: if the RBI was convinced about the reasons to increase rates, then there was no need to offer the explicit guidance of a pause in December, even if that is what it eventually did. Conversely, if it was convinced about the reasons for a pause, then there is no need to raise rates.
The gem in the policy statement is that the RBI thinks that its action (rate hike) and guidance (a pause in December and rates peaking if inflation conforms to the anticipated trajectory) will contribute to stimulating investment activity. The central bank appears to have some strange notions about how investment activity takes place, even as it raises interest rates. In any case, thanks to the partial misreading of the causes of inflationary pressures and the resulting medicine, we experience lower growth but still-high inflation.
There are legitimate risks to the inflation trajectory from the uncertainty regarding the nature, timing and magnitude of the likely increases in some local administered prices needed to check the fiscal slippage and from global commodity prices. One of the troubling features of tracking the Indian macroeconomic scene over the last year has been the lack of a reliable forecast of the inflation trajectory. This applies equally to the track record of inflation forecasting by the RBI and the private sector. Indeed, one of the factors contributing to elevated inflation expectations has been the repeated misses in actual inflation playing out as expected.
There were several causes for the mishap in forecasting India’s inflation. One, the uncertain pass-through of higher global commodity prices made the inflation trajectory prone to more-than-usual revisions. These were also affected by the uncertainty around the timing and magnitude of the government’s revisions of administration prices for fuel and fuel-related categories.
Two, the severe drought in 2009 caused a surge in food inflation. Typically, such weather-related shocks are temporary but that was not how it played out this time. While headline food inflation did come off, it remained elevated owing to a combination of structural factors affecting protein-based consumption and the government’s policy of increasing minimum support prices for agriculture produce. Higher inflation is partly an outcome of the broader government policy of improving the terms of trade for the agriculture sector/rural economy. Interestingly, the rise in food prices since early 2004 has significantly exceeded the increase in the prices of non-food manufactured goods.
Three, in early 2011 the underlying drivers of inflation unexpectedly changed from being mainly driven by food to non-food items, especially the items captured in the core category (non-food manufactured goods).
Four, the anticipated fiscal consolidation has been much slower and weaker that what was appropriate for managing the economic cycle. This, in turn, has kept inflation and inflation expectations elevated. In fact, the RBI’s aggressive monetary tightening this year was partly to make up for the lack of meaningful fiscal adjustment.
Five, data quality remains an issue and revisions to the provisional WPI inflation have sometimes been one percentage point or even higher.
Six, there have been far too many supposedly smart people in government conducting unbridled open-mouth operations and offering numerous guidance on inflation, none of which materialised.
Finally, the lack of supply-enhancing measures by the government ensured that the aggregate demand-supply imbalances also contributed to keeping inflation high. In the final tally, the latest policy statement showed the RBI tripping on what appears to be a forced compromise and its own style of guidance is part of the problem.
The author is senior economist at CLSA, Singapore.
The views expressed are personal