It’s time to raise policy rates rather than change stance

First phase of the Flexible Inflation Targeting (FIT) for India started in August 2016 and the next in April 2021, which is due to run till March 2026. The inflation target was renewed with the CPI target kept at 4%, with the upper tolerance level at 6% and the lower tolerance at 2%. The 2016 notification indicated, among other things that, the key advantage around a target was that it would accommodate unanticipated short-term shocks even while nudging Inflation Expectations (IE) to the centre of the range to which monetary policy will return the economy over the medium term.

The main role for monetary policy through a nominal anchor such as CPI is to deliver low and stable long run inflation and IE. Even as we have seen stable inflation since the start of FIT, IE continue to remain high and sticky. In this regard, it would be useful to look at the bi-monthly Household Inflation Expectations Survey published by the central bank. The key statistics here, include the 3 month and 1 year ahead median inflation expectations. Let’s take a look at the data for 3 periods: May 2016 to March 2021 (first phase of FIT); April 2021 to March 2022 (second phase of FIT that concludes in March 2026); May 2016 to March 2022 (whole period till now where FIT has been implemented).

During the period of the FIT, IE has remained above 7% persistently, which is 1% above the upper tolerance level of 6% and has been closer to the high single digits for both the 3 month and 1 year ahead IE.

For the whole period, while the minimum three month and one year ahead IE at 7.2 and 7.9 have been above the upper tolerance level of 6%, in the second phase of FIT the three month and one year ahead IE have been significantly higher than the upper tolerance level of 6%. It would be interesting to go to the root causes of such high IE in the backdrop of six years of a FIT regime. While food and fuel prices could be a proximate cause, could it be that past episodes, prior to FIT, of high and entrenched inflation has led to an element of IE stickiness. Could the trump card to escape this entrenched IE lie with increased productivity through fiscal policy, which can complement FIT? Clearly, the thrust by the government through capex could be beneficial and transformative in this regard. Even as productivity changes take time and are structural, near term cyclical dynamics call for restrictive monetary policy. The real rates are negative when adjusted for IE.

There has been a considerable shift in inflation forecasts from 4.5% in the Feb policy (with risks characterised as broadly balanced) to 5.7% in the April policy. Given the structural up move in global commodity prices and supply chain effects, inflation in India could be in the region of 6% and above 6% for three successive quarters. A simple Taylor rule that captures inflation deviations from target; output gap and a real rate could provide some intuition to likely policy rate outcomes.

Rates could go above 6% based on policy or 7% based on an alternative forecast especially in the backdrop of CPI at 6.95% and WPI at 14.55%. It would be useful to hike rates soon rather than move from accommodative to neutral followed by policy action. In this regard the period October 2019 to February 2020 could be useful in that, policy moved to calibrated tightening in October 2019 which remained in February 2020 when rates were cut (and policy moved to neutral). The current environment calls for moves the other way around.

Finally, since more liquidity is drained for 14 days which is characterised as the main operation it would be interesting to start thinking about a transition of the policy rate from overnight to a 14-day main operation rate in the backdrop of a tightening cycle.

The author is MD, global emerging markets, Deutsche Bank

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