Belying the expectations of a rate cut, the monetary policy committee (MPC) has not only decided to keep the rates unchanged in its meeting today but more importantly, has shifted its stance from “accommodative” to “neutral’. This is “to assess the transitory effects of demonetization on inflation and the output gap”. The shift marks a significant reversal of policy as it had maintained “accommodative’ stance all through the year. A look at the reason for the same..
An “accommodative” policy works towards stimulating growth by loosening money supply while sticking to the core objective to contain inflation. However, when the threat of inflation re-appears, the stance shifts to “neutral” where the core objective become paramount irrespective of its impact on growth. Even though inflation looks benign at the moment, the policy is supposed to be based on inflationary conditions projected after a year since it takes up to a year for policy rates transmission. And as per MPC’s reading, the inflation is expected to rise to 4.5-5% range towards the end of FY18 and that is what worries it.
Primary reason for inflation is what economist say,”too much money chasing too few goods”. MPC expects growth to pick up around the middle of FY18, thereby, reducing the output gap and pushing up inflation. Lower output gap means manufacturing sector working to fuller capacity which currently stands at about 70-75%. Other than the direct impact, higher capacity utilization also gives greater bargaining power to the manufacturers. MPC is also concerned that inflation in services, which is more dependent on rising salaries and wages, continues to remain high.
Other than this base case glide path of the economy, MPC also cites three upside risks adding to the uncertainty – rising crude prices, volatility in exchange rate and the impact of increase in house rent allowances under the 7th Central Pay Commission which doesn’t affect WPI but has a high impact on consumer prices. Crude price rise pose greater risk now due to higher reluctance of government to cushion the impact and assume higher subsidy burden. As a result, crude price rise can lead to faster transmission and affect the prices of oil dependent segments such as transportation, logistics etc. The good news is that the committee expects growth to recover sharply in 2017-18 from projected 6.9% in FY17 to 7.4% in FY18. This is because of sharp increase in consumer demand held back by demonetization and reduction in banks’ lending rates which should stimulate both consumption and investment demand.