Number Theory: Should monetary policy pivot towards growth?

A couple of months ago, this question would have seemed preposterous.

A couple of months ago, this question would have seemed preposterous. Retail inflation was more than 6%, which is the upper band of RBI’s tolerance band under India’s inflation targeting framework. Real interest rates – adjusted for inflation – were negative or near zero. In April, OPEC-plus, a cartel of oil producing countries, announced a surprise cut in petroleum production generating fear of a spike in energy prices once again. However, there is good reason to call for growth-focussed push at the current juncture. Here are three charts which explain why.

Should monetary policy pivot towards growth?

Inflation, both headline and its key components, continue to moderate

Retail inflation, as measured by the Consumer Price Index (CPI), came in at 4.7% in April, the lowest in 18 months. This is a percentage point lower than the March CPI print and 1.7 percentage points lower than what it was in February . Even core inflation – CPI basket excluding food and fuel – came down to 5.4% from its March reading of 6%. The core inflation value is the lowest since June 2020.

Economists expect headline CPI to fall further . “India’s headline retail inflation in May is likely to fall further towards 4% — the midpoint of the central bank’s target and a level last seen in January 2021, according to a few economists, who expect lower food prices to aid the decline,” a Reuters story said on Monday.

Wholesale Price Index (WPI) has actually contracted by 0.9% on a year-on-year basis in April and the index itself has been flat for three months beginning February .

Real interest rates are already positive and inflation falling further could take them even higher

A 4.7% retail inflation in April means that the real interest rate is 1.8%. This is the highest it has been since August 2019. If inflation falls further, and nominal rates remain where they are, real interest rates are bound to increase further. This will generate headwinds for future investment at a time when non-food credit growth already seems to be losing momentum. High real rates will also hurt consumption spending by forcing households to pay more on mortgage payments. Unless incomes increase, higher mortgage payments will have to be financed by cutting back on other kinds of spending. Both of these could hurt future growth.

Most economists suggest that the rate-hike cycle is over for now

“We believe that RBI is done with rate hikes for now. If it did not hike the repo [the policy rate] rate in the April meeting, when the inflation prints were higher than 6%, we doubt it will hike when inflation has fallen below 6%. In fact, we expect a 25 basis points rate cut in 1Q2024, taking the repo rate to 6.25%”, HSBC economists Pranjul Bhandari and Aayushi Chaudhary said in a note dated May 12. One basis point is a hundredth of a percentage point.

Some experts are also talking about a possibility where both inflation and growth in 2023-24 are likely to be lower than RBI’s projections. “We expect inflation to average 4.8% in FY24, lower than RBI’s projection of 5.2%. We also have a materially divergent growth view, and expect GDP growth at 5.3% in FY24 compared to the RBI’s forecast of 6.5%. We believe a macro regime shift is underway from high growth-high inflation to low growth-low inflation, which is likely to cause RBI to pause in the near term, and shift to rate cuts from October onwards. We continue to project 75bp rate cuts cumulatively in H2 FY24,” Nomura economists Sonal Varma and Aurodeep Nandi said in a note dated May 12.

But things could get complicated if the Karnataka loss increases pressure for fiscal handouts

The fact that the Congress had a bigger advantage among the poor voters in Karnataka and three out of the five state elections before 2024 general elections will see a direct Congress vs BJP contest could lead to competitive fiscal populism.

“Investors could perceive fiscal risk of competitive populism at the Centre and state level. INC’s Karnataka manifesto promises cash handout to women/unemployed youth, free electricity, free cooking gas cylinder etc. At the central level, the extent of MSP increase for different summer crops in July could be a near-term test. In 2019, the BJP had also announced a new cash handout for farmers. Similar kind of measures addressing rural/bottom-of-the-pyramid would be in focus from a fiscal perspective, especially if they come at a cost of capex cut,” Citibank chief India economist Samiran Chakraborty said in a note dated May 15.

A loose fiscal policy could put pressure on monetary policy to adopt a cautionary stance. Put simply, a populist turn in economic policy could derail a pro-growth turn in monetary policy.