The Government has prioritised policy continuity and macroeconomic stability over populism in its choice of the next governor of the Reserve Bank of India. Surprising markets, Deputy Governor Urjit Patel was appointed to take over the reins when Raghuram Rajan steps down early September. Known to keep a low-profile, Patel’s past work experiences have been with multilateral agencies, and public and private sector entities.
With this decision out of the way, the formation of the policy committee is the final (pending) piece of the new monetary policy framework. Inflation targets were finalised earlier this month.
Looking back, the first step towards adopting an inflation-targeting structure and use of CPI inflation as a nominal anchor was taken two years ago. Despite the passage of time, the appropriateness of inflation-targeting in India is still being questioned.
This is not without reason, especially since food, which reacts little to monetary policy, makes up half of India’s inflation basket, and a routinely loose fiscal policy has threatened to blunt monetary decisions in the past. Despite the scepticism, the move towards a single inflation target rather than multiple targets is the right step forward. An official target provides a degree of transparency in policy decisions, helps anchor inflationary expectations, while also ensuring the RBI’s independence. It also gives the RBI (and henceforth the committee) room to manoeuvre to meet goalposts.
At the same time, the Government has given fiscal consolidation precedence over growth, thus providing a more conducive environment for effective monetary policy. Further support to iron out structural constraints of physical and soft infrastructure is also required to ensure supply-side bottlenecks don’t disrupt disinflationary trends.
Until these bottlenecks are repaired, there is a risk that an inflation-targeting central bank such as India’s might tend to run a tight monetary policy during phases of food price shocks. This could prove to be a double whammy if the food price shock coincides with a phase of weak aggregate demand and subdued growth. Hence, the RBI will need to be adaptive, that is, to differentiate between supply-induced shocks to inflation and demand-driven pressures so as not to unnecessarily choke growth.
New framework
Bearing the benefits in mind, the authorities are drawing the outlines of the new inflation-targeting framework. The decision to retain the 4 per cent CPI inflation target (2-6 per cent range) for the next five years points towards policy continuity. It also lowers concerns that growth would take precedence over inflation. While the decision to maintain these targets is encouraging, achieving the 4 per cent target on a sustainable basis will be a challenge.
CPI inflation fell to 4.9 per cent in FY16 from 6 per cent the year before and 9 per cent the year before that. But the downward move was largely due to cyclical factors — global disinflation and easing rural wages at home. In recent months, inflation has begun to creep up again. The structural hurdles of poor infrastructure, rain/groundwater dependency and agricultural bottlenecks must be addressed if inflation is to continue further towards the Government’s 4 per cent target. The market also awaits clarity on how the incoming governor and the new committee will view this new inflation target. How it reacts to any possible overshoot from the 4 per cent mid-point also remains an open question.
For now, we assume that the officials will view 5 per cent as a step target this year and move towards 4 per cent next fiscal. Working with this assumption and a conservative governor, set against a background of firm April-July inflation numbers, the odds of a rate cut in October have fallen.
December will be the next window, hinging primarily on the inflation outlook and the appointment of a dovish policy committee. Further afield, we expect rates to remain steady as the bulk of the disinflationary phase has passed and full-year inflation looks set to miss the 5 per cent target. Apart from the volatile food component, demand dynamics will also be important to monitor ahead of an increase in public sector wages and a pick-up in rural demand due to a good monsoon.
With targets in place, Patel’s views will be important to get a clearer sense of policy direction. Inferring from the tone of his monetary policy report back in January 2014 and his sparing comments since, he appears to be largely aligned with Rajan’s views. This lays the ground for a cautious approach towards rate cuts, while being critical of excessive public spending. Thus, one should expect the new governor to push for active fiscal management and structural reforms to improve the effectiveness of monetary policy on price expectations.
Unknown quantity
While much of his views on mainstream policy can be inferred from past academic papers and occasional public comments, little is known of his thoughts on other aspects, including plans to deal with banking sector stress and financial sector reforms. As a governor, clear and frequent communication on policy and other related issues will become important.
Besides mainstream policy, the new governor will also take office in the midst of the FCNR maturities, where we expect some short-term impact on balance of payments, strain on domestic liquidity conditions and a temporary bout of rupee volatility. However, active liquidity management and tapping available tools are likely to ensure that this impact does not persist. Measures to tackle banking sector stress will be important, especially amidst signs that there is more pain ahead.
Apart from the change of leadership in the RBI, the make-up of the policy committee will also be important.
While the committee marks a shift towards collective decision-making, the known two (of six) members fall in the relatively cautious camp. If the rest of the panel carries shades of the present technical advisory committee, the overall policy bias would be more balanced.
It is worth remembering that Raghuram Rajan took office in the midst of the US taper tantrums when the rupee had depreciated to record lows and foreign investors sold local assets heavily. This required him to immediately take corrective/stabilisation measures. The new governor, by contrast, will assume responsibility in a relatively calm environment, with the emphasis likely to be on policy continuity and maintaining macro-stability.
The writer is an economist and vice-president of DBS Bank, Singapore