INTERVIEW: Varma says MPC must consider growth when pursuing 4% CPIINTERVIEW: Varma says MPC must consider growth when pursuing 4% CPI

INTERVIEW: Varma says MPC must consider growth when pursuing 4% CPI

Informist, Tuesday, Feb 28, 2023

By Shubham Rana and Pratigya Vajpayee

NEW DELHI/MUMBAI - The Monetary Policy Committee faces a high degree of urgency to ensure that headline inflation stays within its tolerance band of 2-6%, but the pursuit of its target of 4% should factor in the additional mandate of supporting growth, Jayanth Varma, external member of the Reserve Bank of India's rate-setting panel said.

"So you have to bring it (inflation) down till a point where you know that we are unlikely to breach 6%. So that urgency is very high. To the safe zone, where you say if something goes wrong, it will still stay below 6.%, so there's no question in that," Varma told Informist in an interview.

As per the framework followed by the RBI and MPC, the stated aim of monetary policy is primarily to maintain price stability, while keeping in mind the objective of growth. It prescribes an inflation target of 4%, within a band of plus or minus 2%.

"Where you can have an extended discussion is having brought it safely below 6%, say you've brought it down to 5.5% or even below 5.5%, then how fast do you want to do the next step of bringing it down to 4%?, he said.

"There I think the dual mandate of the MPC, of keeping growth into account, would be that the MPC could decide where the growth issues are significant and therefore, we could be a little slower in bringing it towards 4%," said Varma.

It was the urgency to bring down inflation below the 6% threshold that prompted the MPC to hike rates by a steep 40-50 basis points each time it met during May-Sep, the initial part of the rate hike cycle, he said.

However, he is of the view that risks to growth now outweigh those on the inflation front, warranting a status quo on rates unless the situation eventually reverses.

Varma was one of the two members who dissented against the six-member committee's resolution to raise policy rates by 25 basis points at its Feb 6-8 meeting.

According to Varma, the cumulative 250-bps hike in interest rates since May would be sufficient to keep inflation under check in the next financial year beginning April. Likely to have done the needful, the MPC should refrain from alluding to further rate hikes through its stance, Varma said.

"That we are on very uncertain territory, and we are quite close to what we need. Some people may think we are a little short, some people may think we are beyond what is required, but I think everybody can agree that we are pretty close to that. If you're very close to that then I think it doesn't make sense to say we'll keep raising rates," he said.

Since the MPC cannot be sure of its next rate action, it should play by the ear at its subsequent meetings and therefore, keep its options open, Varma said.

Even though he is against raising rates further as of now, he is open to the possibility of resuming policy tightening next year if the situation warrants.

"If risk factors start shifting back towards inflation, I would be happy to shift gears immediately. But equally what I'm saying is that if the balance of risks is appearing to be on growth, one should be able to shift in that direction," he said.

In fact, Varma himself would go back to voting in favour of rate hikes if the inflation trajectory becomes a cause for concern again.

"And if the balance of risks shifts towards inflation, I would be very very prompted shifting to a vote hike camp. And I have been on the rate hike camp for a long time, so going back there is not a problem," he said.

Varma clarified that he would not base his assessment of the inflation situation on the latest inflation prints.

"Let me begin with what I will not be looking at - the last month's inflation number. If you look at the last month's inflation number and decide monetary policy it's like driving at the car looking at the rear-view mirror," he said.

Data released earlier this month showed India's annual inflation rate, based on the Consumer Price Index, rose to a three-month high of 6.52% in January from 5.72% in December.

Rather than the inflation prints, Varma would consider forward-looking indicators as monetary policy tends to act with a lag of three to five quarters, he said.

The RBI's internal projections of growth and inflation, surveys of professional forecasters, projections from the global institutions such as like World Bank, consumer confidence surveys, and business expectations surveys would be some of the sources of information that policymakers would rely on, Varma said.

In addition, the outlook on monsoon, geopolitical developments in Ukraine and their consequent impact on commodity prices will shape the outlook on inflation, he said.

"Let us look at how the situation evolves. If growth does hold up and inflation does not come down, we can always raise rates. There is nothing that prevents us from raising rates in June or something if the situation looks like that," Varma said.

OVERESTIMATED PROJECTIONS

Taken at face value, the latest set of inflation projections by the RBI can seem uncomfortably close to the MPC's upper tolerance level of 6%. But Varma believes that the forecasts are probably an overestimate, given that these are premised on an unrealistically high level of crude oil prices.

At its policy review on Feb 8, the RBI projected CPI inflation to average 5.3% in 2023-24. Retail inflation in Apr-Jun is projected at 5.0%, and Jul-Sep at 5.4%. For Oct-Dec and Jan-Mar of the next financial year, the headline number is projected at 5.4% and 5.6%, respectively.

For its projections, the central bank has assumed the price of India's crude oil basket to average $95 per barrel, substantially higher than the $82.21 per barrel on Monday.

Varma said the RBI's assumption of oil at $95 per barrel does not seem well-justified, given that the futures market has been implying a one-year price of $85 per barrel for several months now.

"But crude could also come down, so why are we projecting it at ($)85? And the more interesting thing is that there is no serious attempt at justifying ($)95," Varma said.

"Why do we think ($)95? What are the factors that were causing ($)95? Why do we think that the entire crude oil futures market is wrong to this extent and that it will remain wrong for so many months," said Varma, a professor in finance and accounting at the Indian Institute of Management, Ahmedabad.

"One has to give an explanation for that and that has not been there. So that is what makes me think that that projection is probably an overestimate," Varma said.

He pointed out that around 25% of India's crude oil imports are from Russia, at a discounted price of less than $60 per barrel. The weighted average cost of crude oil for India can thus be estimated at around $70-75 per barrel, Varma said.

"One is, we are not just talking about today's prices of crude, we are talking about futures market's prediction of one-year ahead prices. Second, it was not just for one day it was at $85. For last several months it's been fluctuating around $80-85. That's the second thing that prompts concern about $95. The third thing is that even the $85 Brent crude is not the price at which India is buying crude."

While acknowledging that domestic fuel prices are yet to be cut in response to the fall in crude, Varma said the headroom in oil prices can entail a significant relief on the inflation front.

"It's a huge impact on inflation which has not been taken into account," he said.

UNEASINESS ON GROWTH

Varma said growth seems very fragile with exports falling, fiscal deficit shrinking substantially, private capital expenditure sluggish, and home loan monthly instalments rising.

With capital expenditure staying sluggish, as has been the case for 5-10 years, the burden of pushing growth has fallen on private consumption. However, it remains to be seen if private consumption is strong enough to carry the entire economy, Varma said.

According to the RBI's projections, GDP growth is seen slowing down to 6.4% in the next financial year starting April, from 7.0% projected for the current year.

At the outcome of the policy meeting earlier this month, the central bank projected the GDP growth for Apr-Jun at 7.8%, 70 bps higher than its previous estimate, and 6.2% for Jul-Sep, 30 bps above its previous forecast. For Oct-Dec and Jan-Mar of 2023-24, the GDP growth is projected at 6.0% and 5.8%, respectively.

The MPC member expressed his concerns about private consumption saying that among pockets of private consumption, only those that are consumed by the more affluent section of the society are doing really well, such as sport utility vehicles and luxury cars.

"So, that K shaped recovery we worried about in the pandemic days is still with us. Therefore, a broad-based rise in consumption is still not evident," he said.

According to Varma, the balance of risks has also shifted from inflation to growth. "For almost a year now, the balance of risks were on inflation. We were worried that inflation would go beyond our expectations, but we felt growth would be okay. But looking forward, it is growth that is more likely to disappoint than inflation," he said.

He said inflation expectations are coming down and businesses, in particular, don't see the cost pressures that were present over the last year. The supply shocks caused as a result of Russia's invasion of Ukraine now seem to be dissipating with crude oil prices being the prime example, the MPC's external member said.

CORE NOT STRUCTURAL

Varma is perhaps the only committee member who doesn't seem to be perturbed by core inflation that has remained sticky near 6% for months now. According to him, the current stickiness of core inflation is not structural and only the pass through of cost pressures that emanated in mid-2022.

"You had a series of supply shocks. My assessment is that businesses were reluctant to pass on this cost immediately. What businesses did was that they tried to slow the pace of that price increase. It was staggered over many months. So, if your cost went up by 10%, you didn't push up your output price by 10%. You dribbled that out," he said.

Had companies passed through the cost pressures in a single shot, inflation would have very likely jumped to double digits, Varma said. Now, instead of getting a double-digit inflation in one month and then tapering off, what we are getting is droplets over many months, he said.

The committee member expects to see the core inflation number coming down in 2023-24 once the pass through of cost pressures tapers off. Further, he also expects the demand destruction from the 250 bps of repo rate hikes. "Core inflation will fall, that is my view and if it turns out that it wrong, then let's raise rates," he said. End

US$1 = 82.70 rupees

Edited by Vandana Hingorani

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