If mainstream economy theory is followed, then low inflation and a low growth scenario certainly calls for a rate cut by India’s central bank.
However, economics is not so simple, especially for the six members of the Reserve Bank of India’s monetary policy committee (MPC), who have to come to a conclusion on policy rates by putting together a myriad of indicators which may be giving contrasting signals.
The benign headline inflation – significantly lower than the median inflation target of 4% – and a slowdown in the domestic economy coupled with uncertainty surrounding global growth should make it easier for the MPC to call the shots on slashing interest rates.
But then, policy rate decisions are not always so easy, especially when certain indicators play the devil.
Since the RBI follows inflation targeting regime, one should primarily envisage what could be the inflation trajectory going forward. Food, fuel and core are the three components of the headline inflation which cover the entire inflation basket and the recent trends lead me to conjecture that fuel could be the determining component of headline inflation going forward.
This can be substantiated by the following reasoning. One, food inflation since July 2018 has been very low (including 5 months of contraction during October 2018 and February 2019) and the low base effect could lead to an uptick in food inflation. Since food inflation is a volatile component, looking at month-on-month movement is also imperative.
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The previous 3 months have seen an upward movement in food prices especially driven by vegetable prices. In addition, a farmer who may implicitly not know about the cobweb model – which explains that price fluctuations could lead to fluctuations in supply and cause a cycle of rising and falling prices – but could implement it in the coming months. This means that falling farm prices could translate into lower food supply from farmers pushing up food prices for better remuneration. Hence, the base effect factor and this underlying theory of the cobweb model amidst the uncertain cloud cover (monsoons) could push up food inflation. On the other hand, the prices of core inflation which stood at 4.5% in April 2019 could be seen converging towards food inflation aided by a higher base.
With these two components probably offsetting each other’s impact, the inflation trajectory could be driven by oil prices, which rather than following fundamentals are driven by tweets and uncertain supply announcements. At the moment, the risks to the demand supply dynamics of crude oil looks relatively balanced. Also, the policy announcements of the new government and its fiscal policy cannot be undermined.
The domestic economy is certainly experiencing a slowdown. Though MPC member Chetan Ghate had stated that Q3 and Q4 of FY19 are “kitchen sink quarters” (most adverse), the high frequency indicators even in the first month of FY’20 do not highlight a sanguine picture.
The low growth in automobile sales ,which represents gloomy urban and rural consumption patterns, a contraction in capital goods, intermediate goods and consumer durables and widening trade deficit are all signs of a slowdown in the economy. With government also closing its purses for spending owing to elections, the government component in GDP could see moderation.
Services sector exception
The only exception to domestic growth slowdown is the buoyant services sector. Data on 175 NSE listed services firms for Q4-FY19 shows sales growth of around 17%. Bank credit off-take has also been robust primarily driven by disbursements to services and retail. Bank credit to industry has not been broad-based with banks’ lending only to the large industrial houses.
The low inflation and slowing growth framework of the Indian economy certainly calls for a rate cut. But there is something more than just a rate cut which the RBI needs to be doing and that is addressing the transmission problem. The rate cut of 25 bps inFebruary 2019 only translated into a 5 bps decline of the median marginal cost of fund-based lending (MCLR) as at end March 2019.
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Why has transmission been low? The simple answer to this question is that of the sustained period of liquidity deficit seen in the banking system since September 2018. A rate cut transmission impact is faster when the banking system is in liquidity surplus while a rate hike transmission impact is faster when the banking system is in deficit. Thus, RBI has been closely monitoring the banking system liquidity and has infused liquidity via open market operations (OMOs) and long term currency swaps.
Most of the advanced economies have softened their monetary policy stance in recent months but still haven’t cut interest rates. On the contrary, India has reduced rates by 50 bps since February’19 highlighting a slowdown in the domestic economy.
The MPC members have to face a trilemma of a probable pick-up in headline inflation, slowing growth and transmission issues. By keeping inflation within the target range, a rate cut in the June policy will support growth concerns but not without addressing transmission issues by liquidity infusion.
Sushant Hede is an Associate Economist at CARE Ratings Ltd. The views expressed here are personal and do not represent that of the organization.