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View: When commentary drowned the interest rate action

Rate setting is more forward looking than the past data.

, ET Bureau|
Updated: Feb 08, 2019, 10.13 AM IST
Reserve Bank of India Governor Shaktikanta Das delivered a double treat in his maiden monetary policy review on Thursday –– an interest rate cut and a shift in monetary policy stance. But there were hardly any celebrations. Why wouldn’t investors cheer the lowering of cost of funds or a big relief for banks that would release Rs 12,500 crore in capital that could be used to lend to businesses?

When the previously firm Federal Reserve Chairman Jerome Powell tones down the need for raising interest rates or shrinking the balance sheet due to a shift in pace of economic growth, what should an emerging market central bank do when its inflation rate is just about half the target it is given to achieve?

Rate setting is more forwardlooking than the past data. Although the past price pressures indicate the way ahead, it is difficult to accurately forecast future prices. The failure of central banks across the world –– from the Fed to Bank of Japan to the RBI –– to predict the level of price rise is a testimony that it’s not a perfect science.

The latest Consumer Price Index reading was at just 2.2% and the target for the MPC is to keep at 4% with a flexibility that it could move in a two percentage point band either ways.

Furthermore, the forecast for the next fiscal’s third quarter is just at 3.9% including the likely government breach of fiscal deficit target. If that is what data at hand show, what is causing the worry? It may again be communication and perception.

When India chose the CPI for inflation targeting, it was hailed as that’s what the doctor ordered. Because average Indian household’s biggest chunk of expenses were food related and that’s why the CPI index has food items weighing more than half. If it was right at the time when it was chosen, why is it not so now?

It is just the phobia of repeating the mistake. When Duvvuri Subbarao was slow to raise rates arguing that food price rise couldn’t be contained with interest rates, it went out of hand to reach double digits.

Subsequently, under Raghuram Rajan and Urjit Patel, the market was conditioned to anticipate a rate reduction only when there’s enormous conviction. That was reflected in Viral Acharya’s dissent on rate cut.

Some economists argue that core inflation, barring food and fuel, is running at 5.5% for months and that could spiral out of control. Of course, it can. But Governor Das was firm that the MPC has done its math on core inflation which is driven by health and education and that could be one off.

With enough data and sufficient arguments, why did it turn out to be a tame affair for the markets?

Markets mostly react to words than deeds. When the expectation was a shift in stance, the MPC delivered more than what it was keen to digest.

It is also read, rightly or wrongly, that the action was not that of a conservative MPC. Unfortunately, the commentary that followed was conservative with more emphasis on incoming data which neutralised the rate action. Instead, a pause with a shift in stance accompanied by a commentary that the RBI would ensure surplus liquidity would have been magic in an economy where monetary policy transmission has been poor. It is anyone’s guess as to whether the MPC would be proved right or not, but he has put an end to the ambivalence on what matters to MPC — headline inflation or core inflation. It is just the CPI numbers. Period.
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