Posted by: Deepa Vasudevan on Mon, Apr 29th, 2013
Issues in Monetary Policy
On the eve of the May monetary review, a view has emerged that the RBI will definitely ease monetary policy by cutting the repo rate, with or without a reduction in CRR. Polls of market experts predict anything between 25 to 50 basis points reduction in rates next week. The near-consensus on a rate cut is based on the present growth-inflation dynamics of the Indian economy. Since the start of 2013, growth has slowed down sharply, and inflation has come off the double-digit levels seen in the last two years (Pic 1).
Pic 1: Declining IIP, Falling WPI
In theory, therefore, RBI could reduce interest rates to stimulate investment, without running the risk of triggering inflation. Inflationary expectations have been somewhat reduced by a combination of factors: stable crude prices, expectations of a normal monsoon, and falling commodity prices. External factors are favourable: falling gold prices would limit rupee depreciation, and therefore reduce the impact of imported inflation. The Finance Minister is wooing foreign investors with talk of more reform and fiscal restraint; advocates of monetary easing imply that RBI could support his efforts by ensuring cheaper availability of funds to the financial system.
A more nuanced argument comes from an examination of core inflation- or inflation stripped of its volatile food and fuel components. Core inflation based on the WPI has dropped to 3.5%, the lowest in three years (See Pic 2).
Pic 2: Core and Headline Inflation
The RBI tracks core inflation closely; one reason is that it can be interpreted as a measure of corporate pricing power. To understand this, let us break up WPI into its three main components: Primary articles (weight in index: 20.1%); Fuel and power (14.9%); and Manufactured products (64.9%). The first two components include, mostly, prices of items that are used as inputs in the manufacturing sector (such as cereals, oilseeds, minerals, metals, electricity, coal, oil). The third component includes output prices of manufactured products.
Core inflation is defined as non-food manufacturing inflation, and computed from the third component. Essentially, prices of manufacturing inputs are excluded in the calculation of core inflation, but included in headline WPI. This means that core inflation captures changes in final output prices of the manufacturing sector. The component indices: WPI-Primary and WPI-Fuel and Power represent indices of input prices.
As Pic 3 shows, input prices were either volatile or rising but core inflation has been trending downwards for the past three quarters. The implication is that corporates are unable or unwilling to pass on the impact of higher input costs to customers by raising output prices. This is because demand for their products is not sufficient to push through a price hike. In other words, pricing power has reduced due to weak demand.
Pic 3: Input Prices and Pricing Power
Though not a happy state of affairs for the corporate sector (margins will fall, sales may stagnate), this is a situation that a Central Bank is well-equipped to handle. Demand side issues have classic macroeconomic solutions. A significant rate cut, say 50 basis points, accompanied by a small CRR reduction would reduce lending rates enough to spur credit to industry and retail borrowers. Ideally, this should stimulate household consumption and corporate investment. For the first time since the rate cycle turned in 2011, the RBI seems to have a clear mandate for easing money supply.
Whether rates will actually be cut would depend on two factors.
First, core inflation as measured by the Consumer Price Index (CPI) continues to be at 8% levels, and headline CPI inflation is at around 10%. For the average consumer, prices are high and rising; so inflationary expectations will also be high. The RBI has indicated in the past that anchoring inflationary expectations, even if it comes at the cost of growth, is necessary to maintain economic stability.
Second, the current account deficit is expected to reduce from the record high level of 6.7% of GDP seen in Oct-Dec 2012, but the full year’s deficit will still be much higher than a sustainable level of 3%. If falling rates reduce foreign inflows and/or domestic financial savings, then the deficit has the potential to grow into a balance of payment crisis. Both these factors will weigh on the final decision on monetary policy.
 This is RBI’s definition of core inflation. There are other ways of measuring core inflation. For example, the rating and research agency CRISIL measures core inflation as manufacturing excluding food and base metals.
Deepa Vasudevan on Mon, May 6th, 2013 9:14:34 am
The difference between WPI and CPI appears to be largely due to the higher weight of food prices in CPI, and the fact that food prices have risen faster than many other components.
Pravin Taparia on Thu, May 2nd, 2013 12:05:41 am
Tthough market is anticipating a rate cut of atleast 25 bps, I dont think there will be rate cut in May 2013 policy as the RBI in its last policy meet clearly indicate no rate this time, further inflation is still the way above the RBI,s comfort zone and moreover increase in index number of primary articles, food and manufacturing is a bit concern and even revision of previous month's infaltion is also on a higher side leaving less room for the RBI to go ahead with a rate cut in May 2013 policy meet.
Prakash Kartha on Tue, Apr 30th, 2013 4:13:05 pm
Since WPI is related to the price of goods bought by the sellers/traders and CPI is related to that bought by the end customers, whether it could be interpreted that rate of change in above indices (WPI & CPI) is driven/generated by middlemen (wholesalers & traders)
Saurav on Mon, Apr 29th, 2013 4:02:40 pm
Thanks for the article Ms. Vasudevan. Indeed it captures the present scheme of things quite comprehensively. While it is more or less evident that the rate cut is imminent, and the yield movements have also corroborated the optimism, it is another matter that RBI might decide to walk the path of caution and hold rates purely from BOP control measure point of view.