Sunday, February 12, 2017

Monetary Policyand Growth


     RBI has been behind the curve on monetary policy for the past 18 months or so. My forecasts of inflation, on the basis of which I have recommended greater easing of monetary policy(in the TAC on monetary policy till July), have been lower than RBI forecasts, and closer to actual CPI results. ( ,
     A week before the RBIs February monetary policy(8/2/17) I had said in a long interview, that RBI's MPC should reduce repo rates / loosen monetary policy, but it was very unlikely to do so ( ) . This was because the MPC would focus on global conditions such as world prices and interest rates (possibility of US FED rate rise, forecasts of higher world growth by WB, IMF etc) than on domestic conditions such as the dramatic fall in inflation, slower GDP growth and declining fixed investment. This forecast has unfortunately come true. Worse, the change in guidance from "accommodative" to "neutral" signals an unfortunate tightening of monetary policy.

CPI or Core CPI?

     Now that CPI inflation is down to 3.5%, the inflation target seems to be shifting to "core CPI inflation" which is currently a few tenth of a percent points below 5%. In adopting the "flexible inflation targeting " approach, the RBI had also adopted a single measure of inflation CPI and junked the WPI and sectional CPIs. Further it had adopted CPI rather than core CPI because food is very important part of a Indian budgets, & econometric analysis shows it feeds into core inflation much more quickly & effectively than in the average emerging market or Developed country. Talk of core inflation can therefore send confusing signals.

Effect of Tight policy

    Excessively tight monetary policy has during 2016-17, resulted in a rise in the real interest rate, an appreciation of the real exchange rate (REER), a slower growth of consumer credit and a slower recovery of GDP in 2016-17 H1 (-0.25 to -0.5%). It will have similar negative effect in H2 of 2016-17, compounding the negative effect of demonetization on real estate, housing, automobile & consumer durable purchases.  Given the fragmented Indian financial market, the effect of tightening monetary policy through high real repo rates is primarily through organized/large corporate sector & real estate/durable goods demand. This problem was exacerbated by demonetization & should have been compensated by greater monetary easing than earlier required.

    Going forward ie in H2 of 2016-17, the negative effect of tighter monetary policy will extend to (non-globalised part )corporate investment. In other words the tightening of monetary policy signaled by RBI guidance moving from accommodative to neutral will now begin to effect corporate investment also, given the projected revival in the US and world economy generally. The twin balance sheet problem, though real, is less relevant for the domestically oriented part of the corporate sector, which is not constrained by global excess capacity/less effective demand. Thus the negative effects of monetary tightening, will be felt both in demand for real estate & consumer durables but also for the first time on corporate Investment.

Monetary Transmission

 Historically the monetary transmission rate has been about 40% i.e. 1% point reduction in Repo rate has resulted in a 0.4% reduction in average lending rates. Compared to this benchmark, the current transmission rate is higher despite large NPAs. There is therefore, a puzzling inconsistency in expectations of higher transmission, given the reality of 20% PSB NPAs.

Monetarism post-GFC

     Global Monetrist ideologues have been repeatedly proved wrong during 7 yrs since the Global Financial Crises(GFC), but financial markets still listen to them and follow them respectfully. The fact that they were largely right for several decades before GFC doesn't excuse their failure to understand GFC & post-GFC economy. As I have said many times before, the large success that conventional fiscal-monetary policy had in developed countries, in the second half of the 21st century, is no longer relevant to a post-GFC world.

Growth Forecast (23/2/17)

   I have made growth forecasts virtually every year for the past 25 yrs. The maximum uncertainty I have had in the past is a + or - 0.5%. Perhaps occasionally an asymmetric 0.75%. This is the first time I am putting a band of 1% point on each side of my mean forecast for the year 2017-18, because there is a huge uncertainty on both the domestic and the global side. This is further magnified by uncertainty about how the monetary policy committee and other policy organizations will react to these sources of risk.
      On the external front multilateral organizations are predicting an increase in World growth by up to 1% point and markets are predicting two upward adjustments in the US FRBs policy rate. On the downside are the political developments in the USA and Europe and the consequent uncertainty on geo-economic front and their consequent negative effect on world growth. Further, forecasts of World growth recovery have proved over optimistic many times since 2009.
  On the domestic front the big uncertainty arises from demonetization and its impact on consumer behavior as well as the related measures that govt has taken and has hinted at taking. In the absence of data and historical experience of such a demonetization. Most initial forecasts have been determined by personal & political biases. Even though I have estimated the  growth loss for 2016-17 at between 0.25% to 1%, the speed of the recovery in 2017-18 remains uncertain. This is because we don not know how pronounced the hysteresis effect will be, after sufficient cash has been injected back into the economy. That is the recovery could be a very sharp V shaped one or it could be U shape with negative effects lingering for a few quarters.
  Therefore my bottom line at this point is a GDP growth forecast for 2017-18 of 7.5% +/- 1% (ie 6.5% to 8.5%). 

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