The monetary policy committee (MPC) meets this week at a time when the drum roll for sharp rate cuts is getting louder by the day. The most recent data backs the case for a reduction in policy interest rates. Inflation is below target. Economic growth in the last quarter of the previous fiscal came down far more sharply than most economists expected. The decline in investment activity continues. The rupee seems overvalued.
However, the situation is more complicated than most believe. Monetary policy should not be made by looking at the rear-view mirror. As Milton Friedman famously reminded us, it works with long and variable lags, so what the MPC decides this week will affect real economic variables only three or four quarters down the line. A lot then depends on where economic growth and inflation will be four quarters down the line.
One tricky question that the MPC will have to grapple with this week: Is the sharp decline in gross value added (GVA) growth in the March quarter a temporary event, is it the latest episode in a cyclical downturn that began much before demonetisation, and will its effects persist in the quarters ahead?
The standard view is that monetary policy that seeks to stabilize inflation over the medium term should look past temporary demand shocks. The optimal policy response should be quite different if potential growth comes down through a process of hysteresis. It is very difficult to say with certainty right now how long the impact of demonetization will be felt on economic activity. Will it be temporary or persistent?
The evidence is mixed. The recovery in consumer spending suggests that demand is recovering smartly as currency is injected into the economy. On the other hand, the decline in core GVA growth over the past few quarters suggests that India is in the midst of a longer cyclical slowdown that accelerated because of the demonetisation shock. The final decision on policy interest rates will depend on how the MPC looks at the fourth-quarter data on economic activity.
There is an analytical challenge on the supply side as well. It is well known that demonetization has hurt the informal sector more than the formal sector. It is still not clear how quickly supply chains have been rebuilt as new currency became available in the economy. This matters for monetary policy. A monetary stimulus to demand when the supply side is rigid because of broken supply chains could have inflationary consequences.
The inflation data should also be handled with care. There is no doubt that inflation looks benign right now—thanks to a combination of tight monetary policy by the Reserve Bank of India as well as deft handling of the food economy by the Narendra Modi government. Both core inflation and food inflation have drifted down.
There are three risks in the future. One, the pending increase in house rent allowance (HRA) for Central and state government employees will push up inflation. Two, the potential dislocations when the goods and services tax (GST) is rolled out have to be taken into account. Three, there could be a round of global financial instability as the US Federal Reserve begins to reduce the size of its balance sheet later this year.
The Economic Survey written by economists in the Union finance ministry had pointed out in January that the true impact of demonetisation could be better understood by looking at nominal rather than real growth. It is worth pointing out that the growth in nominal GVA in the fourth quarter of fiscal 2017 came in at 11.3%, the highest in many quarters. Some economists in the private sector have asked whether the new deflator used by government statisticians has overstated the decline in real growth.
The interest rate decision this week may thus be a very close call. A lot depends on how much weight the members of the MPC give to the latest economic data and how much to future uncertainty. The final decision may not be unanimous this time because of the complexity of the situation.
This newspaper believes that policy caution is perhaps warranted because of the several known unknowns ahead—the possibility of hysteresis, the state of informal sector supply chains, the dislocation during the transition to GST, and the shrinking US monetary base. The Indian central bank should keep its finger on the pause button, despite the immediate evidence in favour of a rate cut, but the commentary should be less hawkish this time.
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