Monetary policy committee meeting: Dholakia, Patra differ on inflation path

The minutes of the two-day monetary policy committee meeting show how retail inflation falling to a record low of 1.5 per cent in June changed the mood of interest rate hawks towards a cautiously optimistic outlook.
 
The Reserve Bank of India lowered the policy repo rate by 25 basis points to 6 per cent in the August 2 meeting, with four members of the Monetary Policy Committee (MPC) favouring a cut, as opposed to their status quo mood in June.
 
External member Ravindra Dholakia voted for a 50 basis point cut, while RBI Executive Director Michael Patra favoured a pause. One basis point is a hundredth of a percentage point. This is another instance where Dholakia and Patra differed in their interpretation of the inflation trajectory. Dholakia, who in the June review meet had also voted for a 50 basis point cut, felt interest rates had the scope to fall even further. But he kept his vote for a 50 basis point cut at the moment.
 
“The basic purpose of the flexible inflation targeting framework, according to me, is to move away consciously from the activist discretion-based policy to a rule-based policy,” Dholakia said, arguing readings on inflation in May and June came closer to his own estimates than what the RBI expected. The Indian Institute of Management, Ahmedabad (IIM-A), professor exhorted the central bank to act fast on deeper rate cuts.
 
“In my opinion, the MPC should effect a major cut of 50 basis points in the policy rate without losing any more time,” he argued.
 
In the August 2 policy, RBI forecast inflation based on the consumer price index at a little over 4 per cent by March, excluding the increase in house rent allowance for government employees. In the June statement, the RBI had said it expected inflation to be at 4.5 per cent, including the house rent allowance component.
 
“My estimates based on our independent exercise suggest that base CPI inflation is likely to be about 50 basis points lower than the RBI forecast,” Dholakia said.
 
In Dholakia’s assessment, core inflation is on a declining path with minor spikes and should settle at 3.1-3.5 per cent by March-April 2018 and the headline inflation will also converge around that. The fear of farm debt waivers leading to fiscal slippages had not materialised yet because states had absorbed them in their budgets, he said.
 

Dholakia once again warned about stagnant capacity utilisation, which has remained below 75 per cent for a long time, and said factors were leading to expansion of the negative output gap, the difference between realised and potential output in the economy.
 
“Persistence of the negative output gap imposes severe social costs on the economy that are largely borne by the poor and the unemployed,” Dholakia said, arguing the RBI’s neutral policy stance should be “seriously reconsidered in favour of the accommodative stance”.
 
Patra’s view on the same issues were contrary. Stating that the inflation targeting framework should be forward looking, Patra said, “Setting monetary policy by looking over the shoulder at inflation prints of the recent past runs the risk of time inconsistency with respect to the target.”
 
“To reduce the policy rate now — when inflation is set to rise in a couple of months – will be inconsistent and will undermine credibility,” he added.
 
According to Patra, households’ expectations, as well as professional forecasters’ views, on inflation are on the rise and this direction, rather than the level, is what matters.
 
Patra said the positive base effects in inflation would reverse and turn unfavourable from August. “Why not stay on hold now, watch the shape and slope of the upturn and if it is benign, deliver credible monetary policy that supports the economy?” he argued.
 
“The financial environment is bubbly and frothy. The combination of high valuations in equity and fixed-income markets, an appreciating currency and the persistence of a liquidity overhang in the money market is a perfect recipe for financial imbalance. A rate cut can amplify it if the central bank is seen as encouraging risk-taking,” the RBI executive director pointed out.
 
In the past, inflation targets were achieved with “a considerable amount of good luck”, but “now that we are in a formal inflation targeting framework, why not strive to achieve the mandated target with good policy?” Patra argued.
 
RBI Deputy Governor Viral Acharya justified the RBI’s neutral stance by stating the growth slowdown was rooted in the stressed balance sheets of banks and companies. The resolution process undertaken to address this stress had also resulted in poor transmission of monetary policy, he added.
 
“Attempts to address symptoms of balance-sheet problems with aggressive monetary easing get wasted and can even backfire by misallocating investments, fuelling asset price inflation, creating false hopes of a growth boost, and relaxing the pedal on deeper structural reforms,” Acharya said while voting for a 25 basis point cut in policy rates.
 
“I remain concerned about the impact of farm loan waivers on inflation and growth, due to induced departure from fiscal discipline, shift in the nature of state spending and the crowding out of private credit by further state borrowings from the market,” he added.
 
RBI Governor Urjit Patel said it was not clear yet how much of the recent disinflation was structural and how much was driven by transitory factors. Nevertheless, the house rent allowance for government employees would push up inflation, while its second round impact required caution by policy makers, he added.