RBI Monetary Policy Report

The Reserve Bank of India (RBI) released its semi-annual monetary policy report along with the first bi-monthly monetary policy statement released today.

Some useful extracts from that:

Decline in inflation expectations

(1) The January-March 2016 round of the Reserve Bank’s inflation expectations survey of urban households indicates some softening of inflation perceptions and expectations. The decline in current perceptions and three months ahead expectations – by almost 2  percentage points below the results for the previous round – was more pronounced than in one year ahead expectations (0.6 percentage points).

Both current perceptions (7.9 per cent) and three months ahead expectations (8.1 per cent) in the March 2016 round were the lowest since September 2009.

The RBI Household survey of inflation expectations – March 2016 round -can be found here. It is true that 12-month ahead inflation rate is coming down only slowly. That is par for the course. Indians’ experience with steadily rising cost of living is a long-standing one. The UPA regime took it a notch or two higher from 2007 until 2013. But, India has had an average inflation rate of 7.6% on average for a long time (average annual rate of change in CPI – Industrial Workers for the period 1960-2014). It cannot be erased easily.

(2) Professional forecasters’ 5-year and 10-year ahead inflation forecasts converge around 5.0%.

(3)  Empirical evidence suggests that food and fuel inflation affects headline inflation in India3 through formation of high inflation expectations, wage increases and rise in other commodity prices. The spill-over from food to non-food inflation is found to be stronger during healthy domestic demand conditions4. Understanding the shocks in food and fuel prices and their spillovers could provide meaningful insights for monetary policy in anchoring inflation expectations.

Should monetary policy take into account asymmetric effects?

(4) A random effects ordered probit model on the panel of companies covered in the Reserve Bank’s industrial outlook survey from 2010-20148, suggests that raw material costs, labour costs and cost of finance influence price setting behaviour with a decreasing order of impact.

(5)  Firms respond more often in response to a price shock by adjusting prices upwards than in the other direction. Similarly, strong demand conditions induce higher increase in prices, whereas the likelihood of lowering the price in case demand is weak is lower. This suggests that the response of expansionary and contractionary monetary policies in controlling inflation will also be asymmetric – expansionary policy fuels inflation at a rate faster than contractionary policy can contain it.

This is, of course, a very interesting hypothesis. It cannot be the sole guide or determinant of monetary policy. Indian banks’ behaviour suggests the opposite. They transmit higher rates on to lending rates more quickly than they do when RBI cuts rates. That suggests the opposite of the highlighted sentence above. The RBI report  itself provides evidence for this.

Table IV.2 (page 28) of the report shows that, in response to the rate cut of 125 basis points in this cycle, the deposit rates have come down by around 80-90 basis points whereas the lending rate has come down by around 50-60 basis points. Of course, fresh rupee loans cost 90 basis points less.

Also, in the international context, when there is a debt-deflation dynamic and when rates are already at historically low levels, expansionary monetary policy can fuel deflationary expectations than inflationary expectations. In other words, expansionary monetary policy can reinforce economic pessimism rather than optimism and hence, reinforce disinflation/deflation rather than higher inflation. One has to do a separate and long post on this one.

India has an export problem

(6)  India’s share in world exports has declined from its recent peak of 1.7 per cent in 2014 to 1.6 per cent even as some major advanced economies (AEs) and peer Emerging Market and Developing Economies (EMDEs) gained share (Chart III.6). This suggests that factors such as the rising incidence of protectionism and competitive depreciation might have affected export performance, since depressed global demand is common to all exporting countries.

This is an important chart (I am referring to chart III.6 in the report – p.18). India’s share of world export has declined from 1.7% in 2014 to 1.6% in 2015. China, US, Japan and Korea, Taiwan, Thailand and Vietnam increased their shares. Australia, Russia and Saudi Arabia have seen their shares decline. But, that is explained by the collapse in the price of crude oil. Can India’s decline be explained away by ‘the ‘rising incidence of protectionism and competitive depreciation’? India has a huge productivity and efficiency problem.

Hoping for a good monsoon

(7)  The chance of La Niña increases to 50 per cent in September-October-November 2016. In the Indian context, some of the strongest El Niño years have been followed by La Niña episodes, resulting in bumper harvests.

One hopes that they are right on this one.

Elusive investment cycle

(8) Non-food bank credit, which had slipped into an extended single-digit
growth trough in the first half of 2015-16, picked up in the second half of the year and recorded y-o-y growth rates of 10.7 per cent and 11.3 per cent, respectively, in Q3 and Q4. The upturn is discernible even after adjusting for the operations of Bandhan and IDFC Bank – two new private banks that commenced activity during the year (Chart IV.9a). … By and large, the improvement in bank credit flows has been led by the personal loans  category, especially housing, in which delinquency and collateral constraints are  comparatively less binding.

So, it is not yet a good and convincing story that the pick-up/recovery in non-food credit growth is indicative of an upturn in the investment cycle. Perhaps, not yet.

In fact, Chart III.1 shows that stalled projects in the public sector came down but went up in the private sector. Further, the report also acknowledges that ‘a durable recovery in the capex cycle continues to remain elusive in the face of considerable slack’.

Downside risk to Advance Estimate of GDP growth for 2015-16

Importantly, with respect to GDP growth, the Monetary Policy Report noted that the advance estimate of 7.6% might be subject to downward revision:

(9) Profitability of the non-government non-financial companies has also moderated in Q3, with implications for corporate saving and investment. These coincident indicators suggest that national accounts data for Q4 of 2015-16, especially private final consumption expenditure (PFCE), may be subject to downward revisions from the implicit levels in the advance estimates for the full year. 

The observation on (adverse) implications for corporate saving and investment is important. With credit growth for personal loans picking up, household savings could also dip. For now, it might not have too much of an implication for the current account deficit with investment spending remaining weak. But, India is never too far away from a surge in current account deficit. Its savings rate must go up. Of course, since it is dependent on economic growth, employment and income generation, etc., it simply means getting a lot of things right will also get the savings rate right.

It is important to keep in mind that, in the box on India’s potential growth rate, RBI report suggests that the number is close to 7.0% (page 21).

Improved monetary policy transmission

(10) The Government’s decision to remove the spread of 25 bps on select small savings schemes vis-a- vis G-sec yields of comparable maturities, and introduce a more frequent (quarterly, instead of annual) resetting of the administered interest rates on all small savings schemes effective Q1 of 2016-17 should align small savings rates with market rates and contribute to strengthening transmission. Administered interest rates on small savings schemes have been marked down by 40-130 bps for Q1 of 2016-17 as compared with those for 2015-16.

I personally think that this should go a long way to enhancing monetary policy transmission to commercial banks’ lending and deposit rates.

On monetary policy in the developed world

(11) Although the overall objective has been to raise economic growth and counter deflationary conditions by deterring saving, and encouraging borrowing and risk taking, scepticism has developed about the efficacy of the policy in achieving anything beyond inflating asset prices and depreciating currencies competitively.

This has been Governor’s view for quite some time and I endorse it wholeheartedly.

(12) It is also observed that under negative interest rates, a tendency for resorting to currency depreciation to attract foreign demand gets heightened.

I agree. Of course, the European Central Bank might demur. The Euro, their currency, has appreciated since they announced an aggressive easing of monetary policy. How long can they absorb it is anyone’s guess. My guess is ‘not for long’.

Risks to the downside on global growth

(13) In sum, downside risks to global economic activity have increased. With global commodity prices and inflation expected to remain soft, monetary policy stances continue to be highly accommodative, but divergent. Financial markets remain vulnerable to volatility and flux in capital flows and investor sentiment.

Amen to that. However, specifically, with respect to India, one gets the impression that there is incrementally more hope on a cyclical upturn in the country.

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