Getting output up is critical to inflation control
Given how the BSE Bankex fell 1.2% on Tuesday, it is obvious markets were expecting a rate cut—WPI inflation is down to a 9-month low and CPI inflation to a 2-year low. Even those expecting a pause, with rate cuts a few policies down the line, were taken aback by the hawkishness of RBI’s policy tone. While repo rates have been kept untouched—the reduction in access to overnight repos, though, raises cost of borrowing by 10 bps, according to Deutsche Research—RBI said there was an upward bias to inflation projections. Two statements by Governor Rajan and his team at Tuesday’s credit policy are critical, and hold the key to how interest rates will behave in the rest of the year.
The first is the concept of potential output and ‘output gap’—the more the unutilised capacity in the economy, it is obvious, the greater the downward pressure on inflation. The potential output, Deputy Governor Urjit Patel said, used to be around 8.5% a couple of years ago but is down to under 6% now. In other words, inflation will tend to be sticky as there is no ‘output gap’ any more—it may even be negative, the macro report issued with the policy said, while admitting the concept of potential output and ‘output gap’ was a tricky one, with large error bands. Indeed, if food prices are to rise again—they are at around 8% today but have averaged around 10% for the last eight years—so could overall inflation, necessitating a repo hike. In which case, it is critical to see what steps the next government takes to raise the ‘output gap’. A hike in coal or natural gas production—that’s why the gas price hike was so important—will, for instance, help produce more power and can potentially raise the ‘output gap’; so will, to cite another example, clear guidelines on spectrum trading which will make it easier to expand telecom services growth. Essentially, anything that raises potential output—more savings, more projects coming on stream—will help dampen inflationary expectations. That is quite important since, as demand picks up, chances are producers will want to pass on cost hikes they have absorbed so far.
It is equally important to see what stand the next government takes on the Urjit Patel recommendations on inflation-targeting. While the report has not been formally accepted, RBI seems to have adopted its targets of 8% inflation by January 2015 and 6% by January 2016. Given the mean food inflation of 10% over the last eight years, the 6% target means non-food inflation has to come down to 2%. That is a tall target by any stretch. For the longer-run 4% target, if food inflation remains at mean levels, this requires non-food inflation to come down to minus 2%. Given this stark equation, and the likelihood that the CPI index itself is faulty, sooner rather than later, the next government needs to sort this out with the central bank. Else, elevated interest rates are here to stay.