The fine print of MPC resolution underlines a stagflation threat
The Monetary Policy Committee (MPC) of the Reserve Bank of India has kept the policy rate unchanged at 4% and decided to maintain an accommodative monetary policy stance. These decisions are on expected lines. RBI Governor Shaktikanta Das also unequivocally expressed the central bank’s resolve to aid economic recovery.
“The Reserve Bank remains in “whatever it takes” mode, with a readiness to deploy all its policy levers - monetary, prudential or regulatory. In 7 parallel, our focus on preservation of financial stability continues. At this juncture, our overarching priority is that growth impulses are nurtured to ensure a durable recovery along a sustainable growth path with stability”, Das said.
These statements notwithstanding, the fine print of the MPC resolution does underline worrying trends, including a stagflation (low growth and high inflation) threat for the economy.
MPC’s growth projections are unchanged, yet betray pessimism
The latest MPC resolution has retained the GDP forecast for 2021-22 at 9.5%, which was projected in the June meeting. However, a look at the quarterly projections suggests that the MPC members are more bearish on the economy than they were a couple of months ago. Here’s why. In its June meeting, MPC projected GDP growth rate to be 18.5%, 7.9%, 7.2% and 6.6% in successive quarters (June 2021, September 2021, December 2021 and March 2022) of the current fiscal year. The latest projections have upgraded the June projection to 21.4%. This shows that the MPC believes that the second wave of Covid-19 infections did not do as much economic damage as was expected. The reason annual GDP growth has remained unchanged at 9.5% is that the growth projections for second, third and fourth quarter have been revised downward between the June and August meetings. The MPC resolution does not elaborate on the reasons for this. But this is most likely because of demand-side damage.
There is a significant upward revision in the inflation forecast, with a clear blame on petroleum taxes
MPC now expects the Consumer Price Index (CPI) to grow at 5.7% in 2021-22. This is 60 basis points – one basis point is one hundredth of a percentage point – higher than what was projected in the April meeting. Even if this projection holds, 2021-22 will see the second highest inflation growth since 2012-13, the earliest period for which CPI data is available in the new series. CPI growth was the highest at 6.16% in 2020-21.
While RBI continues to maintain that the current inflation phase is transient and driven by supply-side issues, the actual picture could be more complicated. Consider fuel prices, for instance. The price of India’s crude oil basket (COB) was $69.7 per barrel on August 5. However, petrol was selling at ₹101.84 per litre in Delhi, a level it did not reach even when COB price crossed $100 in the past. The reason for this disproportionate increase in petrol-diesel price is high central and state taxes -- union excise duty and state VAT contributed ₹32.9 and ₹23.5 per litre to the price of petrol in Delhi.
With no significant let up in crude prices even after the OPEC+ deal, the MPC resolution has put the onus of controlling inflation on centre and states cutting taxes on petroleum products. “With crude oil prices at elevated levels, a calibrated reduction of the indirect tax component of pump prices by the Centre and states can help to substantially lessen cost pressures”, the resolution says.
Is it time to question assumptions about India’s potential growth rate?
That the pandemic has disproportionately affected labour (in the labour-capital binary) and the informal sector (in the formal-informal binary) is by now well accepted. Whether at all and to what extent the unequal burden of the pandemic will hurt growth prospects is a question on which there is less unanimity. While one set of economists such as Neelkanth Mishra from Credit Suisse believe that the damage could be minimal because India’s growth was always driven by the top of the pyramid, many others have been pointing out potential headwinds to aggregate demand from the squeeze on incomes of the poor, who have a larger marginal propensity to consume – consumption per unit increase in income – than the rich.
This debate is extremely relevant in judging the efficacy of monetary policy as a growth booster as pointed out by Pranjul Bhandari, Chief India Economist at HSBC Securities and Capital Markets India in a research note dated August 2. “Monetary policy is a countercyclical tool. It plays an important role in closing the output gap. But it is not a driver of potential growth. The RBI would be well served to think carefully about when the output gap will likely close and start gradual tightening prior to that since transmission takes time in India”, she wrote.
The International Monetary Fund defines output gap as “an economic measure of the difference between the actual output of an economy and its potential output”. Potential output is defined as “the maximum amount of goods and services an economy can turn out when it is most efficient—that is, at full capacity”. In monetary policy parlance, potential output is also taken as the limit which can be reached without stoking inflation.
Bahndari highlighted the threat of a reduction in potential output in a research note in May itself. “We were already worried about the scars that the first wave of the pandemic would leave behind – a weak financial system and rising inequality. We had estimated them to drag down India’s post-pandemic potential growth by 1ppt to 5%. We worry that these scars may deepen further with the second wave”, she wrote. When read with the fact that India’s growth rate was below 6% even in the pre-pandemic year, there is all the more reason to worry.