MPC yesterday - Bollywood Policemen & the Camel's Nose-ring

The MPC’s role yesterday was like that of the policemen who arrive at the climax of old Hindi movies, after the battered hero has singlehandedly managed to subdue the villains.

There is no dearth of macroeconomic villains today – widening twin deficits, uncertain global environment, and inflation fears to name a few. However, by rising by over 60 bps since the last policy, the bruised bond market had pretty much done the MPC’s job for now.

For its part, the MPC delivered – it didn’t waste any needless bullets, and it stuck to its script. It came across as calm and balanced, and gave perfectly reasonable projections for CPI (5.1% for this quarter, 5.1%-5.6% for H1 FY19, and 4.5%-4.6% for H2 FY19).  That seems to indicate that they would look through spikes in inflation, much as they looked through dips in mid-2017, as long as the market (and the hero) behaves. The MPC has been truly flexible, and used the +/-2% leeway well.

Eye of the beholder

One section that stood out to me (admittedly, we see what we want to see!) from yesterday’s MPC statement was: “Apart from the direct impact on inflation, fiscal slippage has broader macro-financial implications, notably on economy-wide costs of borrowing which have already started to rise. This may feed into inflation.” So MPC acknowledges that higher interest rates do feed into inflation? I can almost hear the purists say – hang on, what MPC is saying is that higher rates from fiscal slippage feed into inflation. Okay, so the system differentiates between higher rates coming from monetary action and fiscal action, and accordingly either quells inflation or feeds into it? Really?

My old grouse with the MPC’s mandate is its underlying simplistic premise – that interest rates can linearly control inflation in India. Given India is a borrow to produce economy (household debt is barely 15% of GDP, while non-household debt is 56% of GDP), and not a borrow to spend economy like say the US (where household debt is at 80% of GDP), it isn’t intuitively clear that interest rates can work on aggregate demand and inflation the same way in India, as they do in the US. In fact, there is documented research by Mishra, Montiel and Sengupta (2016) that shows that all things being equal, higher interest rates have NO impact on inflation in India (if anything, they found inflation increases marginally). 

In Praise of Financial Stability

Instead, financial stability looks a better metric to look at than inflation. As long as financial stability looks comfortable, we can consider lower short-term rates (long-end rates is a different story). If not, we have no choice but to be very vigilant on interest rates, and ignore entreaties to support growth.

A year ago, when our twin deficits, external environment, and oil prices all looked in reasonable shape, we could have afforded lower short-term interest rates. In fact, by not bringing down short-term rates adequately, we may have built up external vulnerability, with hot money chasing high real rates in India. We may have also denied our struggling micro-economy a chance for a quicker recovery. We still needed high or higher longer end interest rates though, to ensure that savings did not flow excessively away from debt and bank deposits into asset markets.

The situation now is very different. We have a worsening fiscal deficit (not just in quantity, but also in quality – the revenue deficit has grown, and our capital spend has reduced), a widening current account, an uncertain global environment, and weight of liquidity and positioning notably in equity and currency markets. Monetary policy has no choice but to be tight and vigilant.

All in all, the MPC is spot on currently, but maybe could have been a little more generous with lower short-end interest rates 12 months ago.

The Camel’s Nose-ring

Is there still a nice way in which the current MPC mandate – howsoever simplistic – actually ends up working?

There is a valid argument to be made, in defense of the current MPC mandate.

Our government has the biggest controllable impact on our financial stability and macroeconomic health. The MPC currently holds the government’s nose-ring with the chord of interest rates. A gentle tug, and this reluctant but sensitive camel can hopefully be urged to mind the fiscal gap, alongside food prices. As long as the camel follows the signal from the interest rate tug, we should all be happy. Will all this work in an election year though? Watch this space.