Monetary policy makers have to look ahead through the windshield rather than look back through the rear-view mirror. The monetary policy committee (MPC) will thus make its next move this week based on what it believes to be the trajectory of future inflation rather than the price readings of the past few months.
Let us go back a year ago to further illustrate this bedrock principle of flexible inflation targeting—that the intermediate target of monetary policy is the inflation target rather than past inflation. The Indian central bank had at the time come under immense pressure to slash interest rates because inflation had collapsed. Consumer price inflation in June 2017 was 1.46%. The MPC thankfully held its ground because its forecasting models were predicting a sharp increase in inflation in the months ahead. The same principle applies now. Inflation—especially core inflation—has accelerated over the past few months. The policy decision to be taken this week should be based on assessments of future inflation.
It will be a tough call. The minutes of the MPC meeting in June were dominated by discussions about the impact of higher farm support prices on food inflation as well as the future trajectory of oil prices. There was a shroud of uncertainty on both these fronts. Some of that uncertainty has now dissipated.
The Narendra Modi government has since announced higher support prices for various food items. The impact these will have on headline inflation depends on the extent of actual procurement by government agencies, which, in turn, is subject to the fiscal deficit constraint. Economists at investment bank Nomura estimate that the impact of higher support prices on headline inflation will be between 20-90 basis points, depending on the extent of procurement. The higher end of this range will take consumer price inflation within a whisker of 6%, the upper end of the inflation target.
With global oil prices seemingly range-bound now, the other big worry should be core inflation. The June reading of core inflation was 5.89%. The most obvious explanation for the sharp increase in core inflation is that the output gap is closing rapidly. In other words, India is already growing close to its potential, unless a sharper recovery in the investment cycle pushes up the potential growth rate. The MPC noted in its June meeting that capacity utilization is finally rising, especially in sectors such as steel.
The rise in core inflation will require more analytical attention. One part of it perhaps comes from housing costs, the result of higher house rent allowance (HRA) payments to government employees. This is a one-time shock, so monetary policy should ideally look past it, unless there are signs that higher housing costs are feeding into general inflation. That seems unlikely.
However, the Reserve Bank of India should provide us with a deeper analysis of what is driving core inflation up right now. Soumya Kanti Ghosh of the State Bank of India has argued that much of the rise in core inflation can be explained by the rise in the prices of services rather than goods.
So what lies ahead? The market for overnight index swaps is already pricing two more rate hikes over the next year. The more immediate question is what the MPC could do in its meeting this week. The choice is between a pre-emptive hike right away or a pause till there is more clarity on the impact of higher farm support prices on headline inflation.
It will be a tantalizing close call, for sure. Much will also depend on the response of inflation expectations. The case for a pause will strengthen in case inflation expectations do not respond immediately to the recent rise in core inflation, a test case to understand how well the new monetary policy framework has succeeded in anchoring them.
There is no denying the inflationary pressure in the economy right now. Further interest rate hikes will be needed as the economic recovery strengthens. However, there is a case for the MPC to pause this week till it gets a better understanding of the impact of higher farm support prices on headline inflation, the trajectory of core inflation once the effect of higher housing costs wears out and there is more clarity on US monetary policy. A pause is preferred but a hike will be quite understandable.
What are the factors driving core inflation? Tell us at views@livemint.com