Should RBI cut interest rates?

Critical components of core inflation have shown a sustained decline over the last few months

Which side of the somewhat overheated battle over inflation and interest rates one finds itself on depends on a few things. To begin with it is important to recognise the fact that the Reserve Bank of India (RBI) now seems fixated on getting inflation down to an average level of 4 per cent over the long term, choosing not to take advantage of the mandated 2 per cent leeway on either side of this level. This means that a few months of extremely low inflation data is unlikely to sway its decisions substantially.
 
In taking this long view, the RBI appears to have moved away from “data dependence” in the narrow sense of the phrase. If its decision in the last monetary policy not to accompany massive downward revisions in its inflation with a rate cut reflects its stance it has de facto jettisoned the strategic space available to it in offering a clearly soft economy some symbolic relief in periods of very low prices. Thus unless it is convinced that it is on this path to its steady 4 per cent target level, it would be reluctant to cut the policy rate further. Whether this single-minded focus is the right thing, when there are clear signs of significant economic sluggishness, remains an open question. The way one chooses to answer it would determine which side of the debate she is on.
 
The next question is: Should the steady and somewhat unexpected fall in inflation over the last few months give some comfort to the RBI that it is indeed headed down the journey to the 4 per cent promised land? HDFC Bank’s analysis finds that 70 per cent of the decline in headline inflation in the last year has come on the back of declining food prices — especially of vegetable and pulses. To put things in perspective, if vegetable and pulse prices were rising at the same pace as last year in May, all else unchanged, headline inflation would have been close to 4.9 per cent in May.
 
Traditionally, food inflation is considered to be driven by short-term supply forces and these are by their very nature temporary. Going by the textbook, a central bank should ignore both a sharp rise in prices and a sharp fall in setting its rate decisions. Thus the RBI’s decision not to cut the policy rate despite declining inflation and massive downward revision in its forecasts for this year might suggest that it is following this line.
 

There is some evidence to suggest that food supply management has indeed improved. The case of pulses is interesting. It is true that aggressive imports coupled with price incentives to domestic farmers (high support prices plus bonuses) have played a role in bringing prices down. That said, prices of pulses have historically been volatile with marked upswings and downturns and the current decline looks like any other “crash’’ on any chart on long-term price movements. In any case, optimal supply management is not necessarily about engineering a sharp fall in prices. A price crash has severe income-effects on farmers that need to be handled through another set of responses
 
The government has thus stepped in to “reflate” through direct measures such as declaring an increase in procurement prices and ensuring that supplies are actually procured at those levels. (An extreme glut in the market has meant that the minimum support price has ceased to act as a floor). The hit on farm incomes has also made the clamour for farm loan waivers a little shriller and states now seem to be in competition to waive farm debt. Reflation attempts might not lead to a spurt in agricultural prices immediately but certainly breed inflation pressures in items including food. Add to this the fact that farmers are already pulling out of production of pulses (sowing this year is already down by 20 per cent) and the wheels of the price cycle seem to keep turning.
 
The fall in vegetable prices has a similar story behind it if we believe what some of the northern regions’ biggest traders had to tell us. A rise in prices of onions and potatoes, for instance, over the last couple of years saw a surge in farmers shift acreage to their production. The build-up in supply reached a critical point this year with factors such as demonetisation (that appears to have essentially affected sales of small farmers) playing a role at the margin.
 
The structural problems for these agricultural items have endured. The shortage of storage facilities for perishable items such as fruits and vegetables, and poor quality that constrains the exports of less-perishable items such as onions means that the entire output in a particular season has to be dumped on the market over a short span of time. Without significant improvement in storage infrastructure or stable absorption of supply by a large food-processing industry this inherent cyclicality in prices in unlikely to go away. Thus the risk of a bounce-back in prices of a number of agricultural items remains. This risk is higher for categories that have seen a secular rise in demand (like fruits and vegetable) because of factors like rising income.
 
Thus the recent movement in agri prices might not give the RBI the comfort to change its stance. It is likely to wait for signs of more permanent reduction in volatility. There are of course issues of what is euphemistically referred to as “political economy’’ and this might induce the central back to offer a token cut in its policy rate mid-year. It might, however, be a half-hearted gesture and further cuts seem unlikely.
 
The space to watch is really core inflation (stripped of potentially volatile components such as food). This has come down over the year from 5.2 per cent last May to 4.1 per cent. If we adjust for statistical effects such as the “base effect” it might not be adequate yet to ensure a 4 per cent steady state. Our analysis shows that over 40 per cent of this basket that includes critical items such as health, recreation and education that have been extremely sticky in the past have shown a sustained decline over the last few months. Whether it is a sign of improving supply or a signal that income growth has really decelerated is uncertain. However this is something the RBI needs to consider as it charts it course to steady 4 per cent-ish inflation.

The writers are economist with HDFC Bank. Views are their own