The sharp 120bp reduction in inflation projection to 2.7-3.2 per cent for H2FY19 and 3.8-4.2 per cent for H1FY20 by RBI in its Dec 5 policy announcement is seen as a signal for an impending shift in policy stance back to neutral in the coming months. For many, the central banks decision to keep the policy repo rate unchanged at 6.5 per cent, along with a calibrated tightening stance, comes as contradictory, given that it is already anticipating a steep decline in forward inflation. Indeed, the Governor has hinted that if the perceived upside risk to inflation does not materialise, it would create room for a rate action.
The market has extrapolated these signals as an imminent rate easing in the coming policies, especially in the context of the sharp (30 per cent) decline in global crude oil prices from the Oct peak of USD84/bbl. However, a further assessment of the RBIs earlier actions by us suggests that the bank will likely maintain its calibrated tightening stance for long unless the core inflation declines sharply by 100-200bp from the current 6 per cent-plus due to significant growth shocks such as the demonetization (Nov 2016) or the GST dislocation (mid-2017).
As of now, most lead indicators cited by the RBI suggest an upside risk to core inflation. These include improved pricing power of manufacturing firms, above-average capacity utilization in the manufacturing sector, a rise in purchasing manager index, a surge in non-food credit growth to 15.6 per cent in November 2018 higher than nominal GDP growth, and most importantly, low output gap, i.e., actual GDP growth minus potential growth.
We believe the ambiguous interpretation of RBIs stance is premised on the flawed belief that the monetary policy committee bases its monetary policy assessment on headline retail (CPI) inflation, which is a wrong indicator. For most mature central banks, the relevant target variable is core inflation, which strips out the volatile and transient components such as food and fuel.
However, our assessment suggests that while most of RBIs communication is focused on headline CPI inflation, its rate actions appear to be aligned with its outlook on core inflation, reflecting the true inflationary situation. For instance, the calibrated policy stance is probably in line with RBIs observation that core inflation has remained sticky and is getting broad-based at 6.1 per cent for October 2018. Hence, in our view, there is an urgent need for the central bank to switch to core inflation targeting instead of the volatile headline inflation targeting.
Indeed, the responsiveness of the RBI repo rate to the lags in headline inflation is found to be very low (0.25-0.30 for every 100bp rise in inflation; from the time when the RBI has adopted price stability as its target objective. In contrast, the responsiveness of the policy repo rate to core inflation has been significantly high and characterized by rising lags – from 0.63 to 0.91 over lags of 1 to 5 months. As a result, the shocks in core inflation get completely factored into RBIs policy rate action over a period of six months.
Our analysis also shows that the impact of non-core inflation, i.e., inflation in food and fuel, on core inflation is very little. The cumulative lagged sensitivity of non-core inflation on core inflation over six months is less than 0.20 and is statistically insignificant. Considering the current level of core CPI inflation at 6 per cent-plus what it means is that if the transient non-core inflation remains low, the RBI is unlikely to change its stance in a hurry. The risk for non-core inflation is that it could rise with an expected sudden rise in perishable food items inflation and a renewed hardening of global crude oil prices.
The above assessment also suggests that the long-term inflation target of RBI of 4 per cent (+/-2ppt) is associated with core inflation rather than headline inflation, which factors in the volatile non-core components. Thus, the more relevant core inflation of 6.1 per cent stands significantly higher than the central target of 4 per cent and above the upper limit of the central banks comfort zone. This interpretation probably justifies the RBI holding on with its calibrated tightening stance. Over the past five years, core inflation has averaged at 5.3 per cent and has dipped just below 5 per cent only during 2015-16.
The relevance of core inflation remaining higher than the long-term target of 4 per cent also implies that the real policy repo rate has remained mostly lower than the targeted real rate of 1.5-2.0 per cent. For instance, the real repo rate (repo rate less core inflation) currently stands at 0.4 per cent, with an average of just 0.6 per cent during 2018. Hence, on the basis of real rate comparison, the policy rate has been less than neutral.
Considering a global comparison, the US Fed, whose policy rate is aligned with core PCE inflation, the real Fed rate at 0.25 per cent (2.25 per cent Fed rate less core PCE inflation of 2 per cent) is also much lower than the median estimate of neutral real rate of 1 per cent, i.e., the level at which the Fed rate is considered neither tight nor loose. Hence, with the US Feds guidance for four hikes till the end of 2019 of 3.25 per cent, the Fed rate will be only marginally higher than the neutral level of nominal Fed rate of 3 per cent (2 per cent inflation and neutral real rate of 1 per cent).
The contradictory thing is that while the US core inflation is still a tad lower than the 2 per cent target, Indias core inflation at 6.1 per cent is way higher than the 4 per cent inflation target of RBI. Yet, the real rate for India at 0.4 per cent is only marginally higher than 0.25 per cent for the US.
The upshot, in our view, is that the persistent focus of RBI and the market on headline retail inflation is a misnomer in the context of monetary policy management. It is high time that RBI starts articulating its policy stance based on core inflation, the de-facto core indicator it appears to be following in taking rate actions. In addition, given the fact that the core inflation rate has remained sticky, it is unlikely that the RBI will change its “calibrated tightening” stance in a hurry. The shift in stance toward neutral can only arise if there are unanticipated negative demand shocks.