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

The first phase of India’s flexible inflation targeting (FIT) started in August 2016 and the next in April 2021, which is scheduled to run until March 2026. The inflation target was renewed, leaving the CPI target at 4%, with the upper tolerance at 6% and the lower tolerance at 2%. Among other things, the 2016 Communication pointed out that the main advantage of a target was that it would absorb unforeseen short-term shocks, even if inflation expectations (IE) were pushed into the middle of the range to which monetary policy is returning the economy above the will be medium term.

The main task of monetary policy through a nominal anchor like the CPI is to achieve low and stable long-term inflation and IE. Even though we’ve seen stable inflation since FIT’s launch, IE continues to remain high and sticky. In this regard, it would be helpful to look at the bi-monthly survey of household inflation expectations released by the central bank. The key statistics here include the median inflation expectations 3 months and 1 year ahead. 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 the FIT ending in March 2026); May 2016 to March 2022 (entire period up until now that FIT has been implemented).

During the FIT period, IE remained consistently above 7%, which is 1% above the upper tolerance level of 6% and closer to the high single digits for both IE over the next three months and the year ahead.

While the minimum IE for three months and one year ahead was 7.2 and 7.9 above the upper tolerance level of 6%, the IE for three months and one year in the second phase of FIT was significant throughout the period higher than the IE upper tolerance limit of 6%. It would be interesting to look at the root causes of such a high IE in the light of six years of the FIT regime. While food and fuel prices may be an obvious cause, previous episodes of high and sluggish pre-FIT inflation may have introduced an element of IE stickiness. Could the trump card for escaping this stuck IE lie in increased productivity through fiscal policy, which FIT can complement? The government’s push through capital spending could clearly be beneficial and transformative in this regard. Even if productivity changes take time and are structural, the short-term cyclical dynamics require monetary policy tightening. Real interest rates are negative when adjusted for IE.

Inflation forecasts have shifted significantly from 4.5% in February policy (with risks said to be broadly balanced) to 5.7% in April policy. India’s inflation could be in the 6% range and above 6% for three straight quarters given the structural bullishness in global commodity prices and supply chain effects. A simple Taylor rule that captures inflation deviations from target; Output gap and a real interest rate may provide some intuition for the likely outcome of policy rates.

Interest rates could rise above 6% based on policy or to 7% based on an alternative forecast, especially against the backdrop of a 6.95% CPI and 14.55% WPI. It would make sense to raise rates soon rather than switch from an accommodative to a neutral stance followed by policy action. In this respect, the period from October 2019 to February 2020 could be useful in that monetary policy moved to a calibrated tightening in October 2019, which remained in February 2020 when interest rates were cut (and monetary policy switched to neutral). The current environment requires movements in the other direction.

Finally, as more liquidity is withdrawn for 14 days, referred to as the main operation, it would be interesting to consider moving the policy rate from overnight funds to a 14-day main operation rate in the context of a tightening cycle.

The author is MD, Global Emerging Markets, Deutsche Bank

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