RBI policy: With demonetisation pain still on, rate panel is acting in undue haste

The rate pause announced by the Reserve Bank of India (RBI) on Wednesday isn’t a difficult decision to understand, but the radical change in the monetary policy stance, assuming that economy will escape the demonetisation impact unhurt, certainly is.

This is particularly because Narendra Modi’s demonetisation exercise is still an unfolding, half-told story and no one knows for sure how this is going to end. The policy document explains well the rationale behind the rate pause. When the MPC (monetary policy committee) and RBI expects the economy to pick up sharply post the ‘temporary’ demonetisation impact and inflation continue to face upside risks, a rate cut isn’t a pressing need.

But, the problem lies in the RBI/MPC hypothesis that demonetisation, announced by PM on 8 November, will pass without causing much trouble to the economy. The big gamble here is that the MPC expects the note ban impact to wear off and, in fact, growth to rebound sharply. In this context, the decision of the MPC to change the monetary policy stance from ‘accommodative’ to neutral’ is surprising. This is also puzzling and appears like the MPC acted in a hurry given that its own growth and inflation outlook ahead is filled with uncertainty.



The question is when its own growth/ inflation projections are based on uncertain elements, shouldn’t the MPC have waited a little longer before stating a major change in its policy stance? What if the much referred rebound in growth doesn’t happen in a cash-strapped economy as expected? The MPC/RBI will then be forced to return to an accommodative policy stance to aid the economy. In other words, such a scenario will show that MPC acted prematurely.

The hypothesis of rapid economic recovery reflects in each and every line in the policy document. Consider this comment in the policy document on Wednesday.“Favourable base effects and lagged effects of demand compression may mute headline inflation in Q1 of 2017-18. Thereafter, it is expected to pick up momentum, especially as growth picks up and the output gap narrows. Moreover, base effects will reverse and turn adverse during Q3 and Q4 of 2017-18.”

The MPC expects the inflation projection of 4 percent -4.5 percent in the first half of the next financial year (2017-18) and the 4.5 percent to 5 percent in the second half. It says, “In this context, it is important to note three significant upside risks that impart some uncertainty to the baseline inflation path – the hardening profile of international crude prices; volatility in the exchange rate on account of global financial market developments, which could impart upside pressures to domestic inflation; and the fuller effects of the house rent allowances under the 7th Central Pay Commission (CPC) award which have not been factored in the baseline inflation path. The focus of the Union budget on growth revival without compromising on fiscal prudence should bode well for limiting upside risks to inflation."

More worrying part is that even after three months, the MPC and the central bank still doesn’t seem to know how exactly the demonetisation impact will play out. The MPC itself acknowledges this lack of certainty when it says, “ the committee decided to change the stance from accommodative to neutral while keeping the policy rate on hold to assess how the transitory effects of demonetisation on inflation and the output gap play out.”

Economists have expressed their surprise in MPC’s sudden change in policy stance. “At a time when everybody is concerned about the hit to growth due to the cash crunch, we are seeing that the RBI is fixated with inflation,” Bloomberg quoted Priyanka Kishore, the Asia economist for Oxford Economics in Singapore. “An accommodative stance would have likely served the economy better while the monetary policy committee assessed the impact of demonetisation.”

Reuters quoted Rupa Rege Nitsure, Group Chief Economist, L&T Financial as saying, "It's quite disappointing that RBI has come out with a strongly hawkish policy at a time when growth slowdown has become very acute in the aftermath of demonetisation. Somehow, RBI has not perceived demonetisation as disinflationary, unlike the GOI Economic Survey." "Shifting policy stance from accommodative to neutral at a time when the government is talking about stimulus doesn't make sense," Nitsure said.

The bottomline is this: The MPC could have logically waited a little longer before taking a definitive stance to shift to ‘neutral’ monetary policy stance from an ‘accommodative’ stance, when demonetisation is still a half-told story and external scenario is volatile. The fact is no one, including the MPC, seem to know at this stage the direction in which the demonetisation is taking the course of the economy.

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Updated Date: Feb 09, 2017 14:01:38 IST

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