Mythili Bhusnurmath

Economist and former central banker

As the first of the six bi-monthly monetary policy statements in the year, the Reserve Bank of India (RBI) statement in April sets the tone for the rest of the year. And since it also sets out the bank's reading of macroeconomic fundamentals and how it expects these to unfold in the coming months, it is eagerly awaited by corporates and the commentariat. Last Thursday, both had reason to cheer, the former whole-heartedly and the latter, with a tinge of apprehension, bordering on scepticism. Not only did the RBI keep interest rates unchanged (as expected), it also retained its neutral policy stance and, contrary to expectation, adopted a dovish tone.

RBI statement

Indeed the bank's statement released on April 5 presents a best-of-both-worlds scenario. Growth is expected to improve and inflation, decline. Gross domestic product (GDP) is expected to grow 7.4 per cent in 2018-19, up from 6.6 per cent in 2017-18 and higher than 7.1 per cent achieved in 2016-17. Meanwhile, consumer price inflation, projected earlier at 5.1-5.6 per cent in the first half of 2018-19 and 4.5-4.6 per cent in the second half, is now projected much lower; 4.7-5.1 per cent in the first half and 4.4 per cent in the second half of the year.

Realistic? Optimistic? Panglossian? Opinions differ. But hardly anyone will deny that the dovish tone, particularly on the inflation front, was most unexpected. Indeed it was at odds with the Monetary Policy Committee's (MPC) own assessment of the upside risks to inflation. 'This above all: to thine own self be true', says Polonius in Shakespeare's Hamlet; advice that could well be extended to the RBI's MPC.

Consider. The committee's resolution red-flags 'several uncertainties' surrounding its projections: the revised formula for minimum support price announced in Budget 2018-19; the staggered impact of HRA revisions by various state governments; the possibility of further fiscal slippage, both at the Union and state levels, uncertainties regarding the monsoon, especially its spatial and temporal distribution; the expectation of higher input and output prices by firms polled in the Reserve Bank's Industrial Outlook Survey, higher household inflation expectations and the recent volatility (read, increase) in crude prices.

All reasons, one would expect, to make the normally conservative MPC play true to form, exercise its usual caution and warn of an impending rise in inflation, never mind the recent softening in inflation numbers. Inflation in February 2018 (the latest date for which numbers were available) was only 4.4 per cent. But no!

After listing as many as seven reasons why inflation is likely to inch up and, omitting (somewhat surprisingly) rising inflationary pressures globally, including the US, the possibility of faster-than-anticipated hikes in interest rates by the US Federal Reserve and the growing threat of trade wars, the MPC opted to 'keep the policy repo rate on hold and continue with the neutral stance.'

How hawk turned to dove?

What made the erstwhile hawk turn dove? There are no convincing answers. True, the RBI's inflation forecasts have consistently over-shot actual inflation numbers in the past. True, its forecasting model has been the subject of intense criticism, with no less than the Economic Survey 2017-18 pointing to how in the last 14 quarters, inflation had been over-estimated by 180 basis points (one basis point is one-hundredth of a percentage point) in six quarters. But, to date, the bank has not shown any willingness to re-visit its evidently flawed model. The net result has been a series of missed opportunities, policies erring on the side of excessive tightness despite capacity utilisation being well below potential.

Even as recently as February 2018, the bank raised its inflation projection from 4.3-4.7 per cent in the second half of 2017-18 to 5.1 per cent in the January-March 2018 quarter. Inflation for the first half of the current fiscal year was projected at 5.1-5.6 per cent, before falling to 4.5-4.6 per cent in the second half. In the event, inflation fell to 4.4 per cent in February 2018. The number for March 2018 is still awaited, but by all indications, inflation for the quarter ended March 2018 is likely to be below 6 per cent.

So what explains the sudden volte face; the much more optimistic view of inflation, despite the less benign outlook? Could it be that the bank's inflation model been tweaked? Perhaps! But in the absence of any clarification from the bank, one can only conjecture.

That is not all. A closer look at the policy statement shows it is riddled with contradictions. Not only on inflation where the bank's reading of the tea-leaves seems to be out of sync with the stance and tone of its statement, but also on the growth front. Thus the statement points to improving global demand encouraging exports and boosting fresh investment. But global demand, as we all know, is unlikely to hold up in an environment of growing protectionism; a fact that the Monetary Policy Report released along with the policy statement acknowledges, but the statement glosses over.

So even as the report talks of US tariff action resulting in lower export realisation for India and of possible escalation of trade protectionism around the world as affected countries retaliate and protect domestic markets posing a threat to countries looking to leverage on trade to meet their growth aspirations, the policy makes light of it.

Bank’s credibility most vital

And that leads to the crux of what ails the policy: its failure to carry conviction. Few things are more important for a central bank than credibility. Markets must have faith in the central bank. It must believe the central bank has Oracle-like powers and call right on inflation. It must also have confidence that if, perchance, inflation (and following from that, interest rates), were to deviate from the stated goal, the bank has the tools to bring it to heel.

What we have seen, instead, is both inflation and interest rates follow their own trajectories, divorced from RBI's estimates and policy signals. Thus, interest rates fell sharply in the post-demonetisation period in response to the surge in liquidity, rather than rate action. Likewise, rates have risen in the past few months, despite the fact that the RBI's last rate action was in August 2017, when the bank actually cut its repo rate by 25 basis points. The recent policy statement, unfortunately, does nothing to enhance the bank's credibility.