No Rate Cut: Urjit ‘Don Quixote’ Patel Tilts At Non-Existent Inflation Threat

It is a pity that Ravindra H Dholakia, a member of the Monetary Policy Committee (MPC), could not convince the other five members to cut rates in this year’s second bimonthly policy announced today (7 June). As the lone dissenter, Dholakia appears to have been the only member to acknowledge that the RBI’s earlier call on inflation was wrong. In February, the MPC shifted from an “accommodative” monetary stance to “neutral”, indicating a possible halt to future rate cuts.

In passing up a chance to cut the repo rate, which remains at 6.25 per cent, the MPC seems to be standing on prestige, having prematurely declared neutrality between growth and inflation. With retail inflation below 3 per cent and wholesale inflation below four per cent, and with GDP slowing down in the context of demonetisation and the earlier overhang of bad loans, this was the RBI’s window of opportunity to cut rates. It has missed the bus.

Governor Urjit Patel has flunked the test and fallen behind the curve.

The problem with this approach of extreme caution on rates – based on imagining a worse future – is that there is no need to cut rates ever, never mind what the current inflation or growth reading.

It can always be argued, that the monsoons may fail, so let’s wait. It can always be argued that current data may be misleading, and hence it is better to wait. The central bank can say that fuel prices may now started adjusting upwards, what with the West Asian political uncertainties.

The point is this: one can imagine all the things that can go wrong in future to not do the right thing today. It is called staying behind the curve when the demands of growth clearly call for lower interest rates in a scenario of benign inflation.

Consider the specious points made by the RBI to justify its no-change decision.

First, it claimed that “the abrupt and significant retreat of inflation in April from the firming trajectory that was developing in February and March has raised several issues that have to be factored into the inflation projections; it needs to be assessed as to whether or not the unusually low momentum in the reading for April will endure.”

Comment: If data proves your earlier caution wrong, you can save face by claiming the current data is suspect.

Second, “the prices of pulses are clearly reeling under the impact of a supply glut caused by record output and imports. Policy interventions, including access to open trade, may be envisaged to arrest the slump in prices.”

Comment: Good supply management is not seen as good policy, but as a stored up threat for future price increases.

Third, “the accumulated downward adjustment in the prices of petrol and diesel effected in April has been largely reversed on June 1.”

Comment: Should the prospect of future moves in non-core inflation (non-food, non-fuel) be determining monetary policy? Shouldn’t monetary policy be focused more on core inflation?

Fourth, the policy says that “the easing of inflation excluding food and fuel may be transient in view of its underlying stickiness in a situation of rising rural wage growth and strong consumption demand. Thus, the April reading has imparted considerable uncertainty to the evolving inflation trajectory, especially for the near months. If the configurations evident in April are sustained, then absent policy interventions, headline inflation is projected in the range of 2.0-3.5 per cent in the first half of the year and 3.5-4.5 per cent in the second half.”

Comment: When the RBI’s own inflation projections are well on the right side of the four per cent mid-point of the agreed medium-term inflation target, what is the logic of not cutting rates?

Fifth, the RBI statement also notes that while the “risks are evenly balanced… the spatial and temporal distribution of the monsoon and the government staying the course in effective food management will play a critical role in the evolution of risks.”

Comment: The right course of monetary policy is to reverse easing once it becomes clear that the monsoon is going to be less than favourable, not in anticipation that it may be bad.

Sixth, the RBI notes that the “risk of fiscal slippages, which, by and large, can entail inflationary spillovers, has risen with the announcements of large farm loan waivers. At the current juncture, global political and financial risks materialising into imported inflation and the disbursement of allowances under the 7th central pay commission’s award are upside risks. The date of implementation of the latter is still not announced and as such, it is not factored into the baseline projections. The implementation of the GST is not expected to have a material impact on overall inflation.”

Comment: When growth is a challenge, one would have thought that a slight fiscal slippage or the payment of Pay Commission dues will be beneficial rather than directly inflationary, given excess capacity.

Lastly, “the MPC noted that incoming data suggest that the transitory effects of demonetisation have lingered on in price formations relating to salient food items, entangled with excess supply conditions with respect to fruits and vegetables, pulses and cereals. At the same time, however, the CSO’s latest releases on national income accounts and industrial production attest to the effects of demonetisation on the broader economy being sector specific and transient, as well as to the noteworthy resilience of private consumption. At this stage, it is difficult to isolate these factors or to judge the strength of their persistence. As the year progresses, underlying inflation pressures, especially input costs, wages and imported inflation, will have to be closely and continuously monitored.”

Comment: This is as close as the RBI Governor comes to saying “I have no clue what is going to happen”. So I will sit tight, never mind the dent caused by demonetisation, never mind how badly banks are bleeding, and never mind that companies are seeking rate relief.

A cut in interest rates benefits banks earn higher treasury profits, and companies get marginal debt relief. This is what the RBI needed to do, but failed to.

Perhaps the RBI is embarrassed that it had prematurely shifted to a neutral stance when retail inflation was going to fall further.

By not recognising that it had made a mistake even in hindsight, the RBI has compounded its folly.

Urjit Patel has chosen to tilt at non-existing “inflation” threats.