RBI Decision to Keep Rates Unchanged Sums up the Policy Challenges Ahead

The MPC records the fact that during demonetisation there were “fire sales” of essential items that depressed prices. The unusually sharp fall in CPI inflation in April cannot be taken for granted.

The second bi-monthly monetary policy statement of the monetary policy committee (MPC) was not expected to throw up any surprise with regard to monetary action. On the eve of the policy announcement, on Tuesday, there was total unanimity amongst leading banks and institutions that there will be no change in the policy repo rate – the most widely watched monetary measure.

As of Wednesday, June 7, the MPC has decided to keep it at 6.25%. Since the other rates – the marginal standing facility (MDF) rate and the bank rate are linked to the repo – there is no change in them either. They stay put at 6.5%. Of the liquidity ratios, the SLR has been cut by one percentage point.

One significant feature of all recent monetary policy statements has been the shifting of focus from the repo rate to macroeconomic indicators such as inflation and GVA growth. Indeed these were always important and often posed a difficult choice to policy makers as to which should be emphasised more at a particular juncture. The latest policy statement is in line with recent ones which have adopted a neutral stance. While growth should by no means be ignored, the primary objective is to achieve a CPI inflation target, over the medium term, of 4% within a band of plus or minus 2%.

The decision to stick to the neutral stand is justified on many grounds. Since April, global economic activity has expanded in major advanced economies as well as in some emerging economies. One sure sign of the pick-up in the global economy has been the accelerating improvement in the volume of global trade since the beginning of the year. Prices of key commodities, especially petroleum have shown a softening trend. Investor sentiment across the globe has consequently benefited India.

On May 31, the Central Statistics Office released national income data, which pegged the growth of real gross value-added (GVA) at 6.6%, which is marginally lower than its earlier estimates. An analysis of the data, however, shows a more robust picture than is apparent. While there has been a downward trend in both industry and services, the final consumption expenditure is expected to lift the economy. Add to this the very important and recent prediction of near normal monsoons. Estimates of food production and of fruits and vegetables have been revised upwards.

Retail inflation measured by year-on -year changes in the CPI index plunged to a historic low in April, aided largely by a favourable base effect and a sharp fall in the prices of vegetables and fruits. The MPC records the fact that during the demonetisation period (July-January) there were “fire sales” of essential items that depressed the prices. There is a warning that the favourable developments will not last. The unusually sharp fall in CPI inflation in April cannot be taken for granted. Why? Firstly, the prices of pulses have been reeling under the impact of a supply glut. Secondly, policy interventions including greater access to trade might redress the imbalance.

Thirdly, the accumulated adjustment in the prices of petrol and diesel effected in April have largely been reversed. Fourthly, the easing of inflation excluding food and fuel may be transient in the light of rising wage growth and strong consumption demand. Thus the April reading has imparted a large sense of uncertainty especially in the near months. The MPC estimates that in the absence of policy interventions, headline inflation is projected in the region of 2-2.5% in the first half of the year and 3.5-4.5% in the second half.

Looking ahead, the RBI finds risks to be evenly balanced although the expected successful monsoons and effective food management will play a critical role in the evolution of risks. The risk of fiscal slippages in the back of large farm loan waivers is a major threat and weak bank balance sheets pose grave challenges to monetary management. While the second bi-monthly policy statement may not tread new ground, it is a very coherent elucidation of the potential environmental changes and challenges before the monetary authorities.

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