Wednesday, April 15, 2015

Inflation & Monetary Policy 2015-16


   This note takes stock of inflation and monetary policy during the last few years and draws implications for future. The most important conclusion is the need for a 1 to 2% reduction in the repo rate during the current  year.


          Inflation as measured by the Private Consumption deflator (PFCE) is projected by the CSO in  2014-15 to be 5.4 per cent , down 3.1 per cent from 2013-14 and 4 per cent points from 2012-13.  It is likely to fall by another per cent point to 4.5% in 2015-16. Average annual CPI inflation mirrors this decline, with a 3 per cent fall between 2013-4 and 2014-15. The CPI rise to 5.4% in February (from 3.3% in November 2014) is largely due to effect of unseasonal rains on seasonal vegetables. The marginal decline in CPI inflation in March to 5.2 per cent supports this conclusion. The effect of

Monetary Tightening

          With a nominal Repo rate of 7.5%, Real repo rate (using PFCE inflation) was 2.5% in 2014-15. The reduction of the nominal Repo rate from an average 7.9% in 2013-14 has been too small to keep the real rate from rising from a negative -0.9% in 2013-14 to 2.5% during 2014-15. This represents a sharp 3.4% point tightening of monetary policy at a time when inflation has fallen sharply. The tightening is equally sharp if we use average CPI inflation to derive the real repo rate, which has increased from -1.9% in 2013-14 to 1.7% in 2014-15
        Even though the economy is growing at a little over 7.4 per cent as per the new GDP data with base 2011-12, this is not true of the organized sector of the economy, which is growing at a much lower rate. High real interest rates are choking off recovery of interest sensitive consumer durable sectors like automobiles and housing and also of real estate in general.  Lower interest rates are critical to faster recovery of these sectors. One indication of this is the fact that the index of motor vehicle production in 2014-15 averaged 12% lower than it did in 2011-12. GDP from (Value added in) the Construction sector in 2014-15 is projected to be only 2.5 per cent higher than it was three years earlier in 2011-12.

    As the labor intensive real estate, housing and construction sectors uses a lot of rural migrant labor, the poor performance of these sectors is partly responsible for the documented slowdown in rural wage growth. This, along with a slowdown in agricultural growth can also be linked to the reported softening of rural demand after several years of firm demand. It should therefore be no surprise that demand for industries such as cement and steel supplying inputs to these two sectors are also in the doldrums.

Rupee Appreciation

     The Indian rupee has appreciated by almost 10% in real effective exchange rate terms (REER36 country index). This represents an additional tightening of the monetary policy.  The timing of current and capital account liberalization should be modulated to minimize the appreciation of the exchange rate.  A faster reduction on controls on capital outflows and reduction in import protection can help moderate the appreciation of the rupee and certainly needs to be part of the policy mix.  
     However the real interest rate interest differential with global rates has been rising and is now too high. It is drawing in excessive short term capital flow and leading to real appreciation of the rupee. If there is no change in nominal rates, the ratio of short term (ST)  to medium-long term (MLT) capital inflows is likely to worsen .
      The rupee appreciation is adversely affecting demand for the globally connected, globally competitive parts of the corporate sector (worsening the demand-supply balance), which seems to be operating at 60% to 70% capacity utilization and delaying recovery of fixed investment and the upturn in the corporate investment cycle. This consists of two parts: One the Metals & Mining: With Coal and mining policy being sorted out through transparent auctions, corporate metals and mining sector is likely to recover, followed by fixed investment in the sector. Two, the rest of the globally connected corporate sector.  In this case a correction of the appreciation will lead to faster recovery of demand, profits, ROE , sustaining the shift from debt to equity initiated by the fall in real interest rates. Fixed investment revival will follow with a lag.

      The delayed recovery in the globally connected & competitive (GC&C) sector also adversely effects the recovery in excise and corporate tax collections, which are collected mostly from the large, organsed corporate sector. Consequently both the corporate cycle and the tax revenue cycle(post global financial crisis)  are lagging GDP growth recovery compared to the normal recovery cycle (pre GFC).

       A rise in US interest rates will reverse some of the rising real interest differential, but that is still more than 6 months away. The profit expectation, ROE and risk profile of the globalized part of India’s corporate sector will worsen in 6-9 months if nothing is done to reverse the appreciation.


    Legacy problems in infrastructure, created partly by overoptimistic demand projections and partly by government directed lending by Public Sector Banks (without resolving difficult policy & regulatory issues) have not been resolved as quickly as necessary for speedy recovery of this sector.  They therefore continue to delay PSB (NPA) and corporate infrastructure revival in sectors such as highways. However, Central Government’s expenditure plans have begun a revival in power and railways sub-sectors.  This, along with reforms in other sectors, will also have a positive effect on corporates and banks with non-performing assets in other infrastructure sectors. 

   An obvious implication of the corporate problems outlined above is that the Banking sectors appetite for lending to these sectors is adversely affected.

Expectation Effects

     As a decline in repo-rates gives rise to expectations of debt asset price appreciation that will be reversed after the asset price appreciation, it is not sustainable after interest rates fall. Such expectations argue for sharper, quicker reductions in repo rates rather than in small steps over a long time period.

Inflation & Monetary Policy in 2015-16

  In projecting  inflation for 2015-16,  two factors are significant. First core, non-food, non-fuel inflation in March was 4.4 per cent, which was also the average of the last four months. Core (non-food, non-fuel) WPI inflation in March was even lower at -2.5%. It is reasonable to expect the gap between the two to close, particularly given decelerating inflation in transport, real estate and wages which are relevant elements between wholesale and retail markets. Thus we are already in 2015, well on the way to the 2018 inflation target of 4 per cent, at least as far as core inflation is concerned. Food inflation is currently running at around 6.1% in the CPI, but is much lower at 4.4% in the WPI, indicating that CPI food inflation is headed lower. If government focuses on agricultural reform and as promised in the budget, NITI can develop a consensus among the States, food inflation below 6% in January 2016 and 4% in 2018 is feasible. There is large gap between the CPI (4.5%) and WPI (-10.5%) on fuel inflation, because the complex system of price controls, administered prices and subsidies. However, even if there is some rise in global oil prices during the year, CPI fuel inflation is unlikely to exceed 6%. Thus total CPI inflation is likely to be between 5 and 5.5 per cent.
     Inflation as measured by the private consumption deflator or by average CPI inflation is therefore projected to decline further by about 1 per cent point. If the nominal repo rate remains unchanged, the real repo rate will increase further to 3.1% in private consumption deflator terms and to 2.1% in CPI terms. Such a tight monetary policy has not been seen since high growth year of 2007-8 when CPIIW inflation averaged 6.2% and global inflation pressures were high. Even if the nominal repo rate is reduced to an average of 6.5% for the year 2015-16, the real repo rate will be 1.1 per cent in terms of average CPI inflation and 2.1 per cent in terms of PFCE inflation, more than enough to keep pushing inflation towards the 4% target for 2017. Thus a reduction in the nominal repo rate is urgently required.


   The argument of weak transmission of repo rate movement applies to both rate rises and rate reductions. If transmission of monetary policy signals like the repo rate is weak, a merely signaling of a change in intentions by the central bank can have little or no effect on market interest rates. The central bank may therefore need to make larger changes in the repo rate to have the same effect as in countries where markets are well integrated and efficient.
     It is also sometimes argued that monetary transmission is asymmetric in the Indian system, where ¾ of the assets are controlled by government owned banks.  To the extent that these banks are in turn controlled by risk-averse appointees of the government, part of whose time is spent on trying to minimize government pressure on lending to sub-sectors with high policy or regulatory risk and/or inefficient and failing borrowers (cronies), this has some validity.  In this situation, jaw boning by the Central bank in co-operation with the Government can be a valid instrument for correcting the asymmetry. Beyond this, it suggests that larger changes in repo rates would be required when lowering rates than when raising rates, thus introducing a down ward bias in rates.  
        Historical data indicates that as far as monetary policy managers are concerned, positive inflation surprises have historically predominated over negative ones and consequently the real repo rate has averaged a negative -2.5% or so since 2004. A balancing of these two factors suggests that a 4 per cent nominal  repo rate would be appropriate when inflation is projected to be at the long term target of 4 per cent (+/- 2%), with upward(downward) revision of repo rates if inflation surprises are positive(negative).


    A zero average real repo rate seems to be an appropriate long term target for the RBI, while shooting for a minimum one percent point reduction in the real repo rate for 2015-16. If inflation declines below the conservative projection of 5 to 5.5 in this note, a larger reduction in the nominal repo rate would be warranted.


A shorter version of this post appeared earlier in ET blogs at

No comments: