The monetary conundrum

Breaking from convention, the monetary policy committee (MPC) of the Reserve Bank of India (RBI) decided to reduce the policy repo rate by 35 basis points (bps) in its August meeting. It was then reasoned that a 25 bps cut would have been insufficient and a 50 bps reduction excessive. The macroeconomic outlook has changed significantly since then and policy making has become more challenging. Growth in the Indian economy collapsed to a six-year low of 5 per cent in the first quarter of the current fiscal year. Had the MPC anticipated the extent of the slowdown, a cut of 50 bps would not have looked excessive in August. The central bank lowered its growth forecast for the fiscal year by 10 bps in August. However, as things stand today, economic growth is unlikely to recover in a hurry and the RBI will need to revise its growth projection significantly. Despite the recent volatility in food and fuel prices, in the near term, inflation is likely to remain below the midpoint of the target range. Therefore, lower growth and inflation would warrant more monetary accommodation. The decision will obviously not be as straightforward.

The government has announced several measures to boost economic activity — most notably, a sharp cut in corporate tax rates. The revenue forgone on this account, according to the official estimate, would be Rs 1.45 trillion. Since the government has not revised its fiscal targets, it would be interesting to see how the MPC accounts for the impact. While some analysts believe the tax cuts will push the fiscal deficit to about 4 per cent of gross domestic product, others are of the view that the impact will be muted. Further, despite the RBI's excess capital transfer, lower growth in tax collection would put significant pressure on government finances. If the central bank believes that the deficit would be significantly higher than expected, it will be a risk to the inflation outlook and become an important factor influencing the MPC's decision.

Therefore, in the given economic backdrop, the MPC would do well to deliberate on the following issues. First, fiscal expansion will affect transmission and a policy rate cut may not have the desired effect. Bond yields have gone up after the corporate tax cut. Excessive intervention through open market operations — to keep bond yields low — can become incompatible with the central bank's inflation-targeting mandate. Further, the MPC will have to see how inflation would behave over the next one year and beyond. Possible fiscal slippage and volatility in food and fuel prices can make things tricky. Second, the committee should review the utility of its decision of breaking from convention to lower rates by 35 bps in the last meeting. Evidently, it was an unnecessary change and should have been avoided. The market saw it as a consequence of limited policy space and pushed up the bond yields. Third, the global economic environment is becoming increasingly uncertain on account of trade tensions and geopolitical risks. Thus, the central bank would need to preserve policy firepower to deal with the consequences of emerging global risks. 

To sum up, there is space for monetary easing, but decisions from here on will need to be carefully thought through and supported by clear communication. A decline in growth should not be used for any kind of policy adventurism.

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