Difficult to see what is keeping RBI from cutting rates
Given the manner in which RBI Governor Raghuram Rajan dismissed FE columnist Surjit Bhalla’s focus on minimum support prices (MSP) as the single-largest determinant of CPI inflation, you would be tempted to think RBI didn’t believe MSPs matter much. Yet, even if you ignore Bhalla’s spirited defence of his model in yesterday’s FE, the Urjit Patel committee report that first talked of inflation-targeting also cites the sharp hikes in MSPs while talking of the sudden and persistent increase in inflation levels since 2008—while Patel didn’t provide an econometric model, the fact that it singled out MSPs suggests it thought they were important. All of which makes you wonder what it will take to get RBI to cut policy rates now that CPI inflation levels are down to a 6-year low and WPI inflation to a 5-year low. Indeed, given RBI’s target CPI inflation of 8% by January 2015 is likely to be undershot, there is also the issue of whether RBI models are delivering the kind of results they should.
Most bank economists argue, as does RBI, that inflation rates are down due to the base effect and once this disappears, in a few months, inflation will be back to being high. Seductive as that sounds, it doesn’t quite work that way. For one, CPI growth in September 2013 was 9.8%, a level that is not dramatically higher than in the previous months—only if it were much higher would there be a ‘base’ effect which would make September 2014’s 6.5% CPI appear low. Indeed, if there is a base effect, it applies really to November 2014 CPI since, at 11.2%, CPI inflation in November 2013 was clearly an outlier.
Indeed, the question to ask is why CPI fell the way it did, from 11.2% in November 2013 to 8% in February and to 6.5% in September 2014. For one, even if MSPs don’t account for as much of the change in inflation as Bhalla posits, there is little doubt their impact is significant—multiply the increase in MSP with the amounts FCI buys, and you see just how much additional funds were being pumped into the rural economy every year which, without any commensurate increase in productivity, just got translated into inflation. Given how muted the hikes in MSP have been, the inflationary impact will be that much more muted now, and there is also the impact of the government trying to sell off FCI stocks of wheat and rice to lower prices in the market. Add to this the trending down of commodity prices globally, especially those of crude, and that’s another reason for why inflation is coming down as fast as it is. Given how iffy global growth is, there are few analysts who are looking at this trend reversing in a hurry. As for India, given the scrappy performance of IIP and other variables—bank credit growth is likely to be the lowest this year since 1997—the chances of demand-induced inflation also look a lot less; to the extent corporate bottomlines have held up, this has more to do with falling raw material prices than they have to do with toplines rising. RBI needs to wake up to this reality.