Ashish Agarwal
Founder, India Business Analysis | IIT Roorkee, IIM-C alumnus

The Monetary Policy Committee’s recent decision to cut rate by 25 basis points does not come as a surprise, since CPI inflation has fallen from 3.4% in October 2018 to as low as 2.2% in December 18. However, a closer analysis of different price components reveals that the Committee may have taken the bait, which was not called for. It would not be surprising if RBI goes back to monetary tightening a few months from now, whenever crude prices record a sudden, sharp jump or food prices emerge from the current deflationary trend!

A rate cut just six months after increasing it, and a change of stance from “calibrated tightening” to “neutral” — having moved the other way round just four months ago — gives a sense of the highly volatile price environment and policy challenges being faced currently.

While the Committee has decided to aid growth, as inflation appears under control, the actual inflation condition is not so benign. More worryingly, the three different groups, namely, food, fuel, and items excluding food & fuel (broadly, core inflation) are showing highly divergent trends. While food inflation has fallen sharply (with about 30% of the items showing deflation), inflation of fuel group stands at 4.5%, which, as against inflation of 8.5% in October, implies a huge respite.

However, core inflation, the most important of the three, stood at 5.6% in December, 2018—down from 6.2% in October, but still extremely high and close to the upper-end of the stipulated inflation range of 4% +/- 2%. This remains a serious concern; and should have been the determining factor, rather than the decline in other prices. Even though the Committee, and the economy, might be drawing comfort from low food prices, it is not a good sign; and is, in fact, an important reason for the current distress in the agricultural sector. The prices need to be supported through government measures (may be by incentivizing exports, and so on).

Whether a rate cut can provide any support to food prices is difficult to visualize. Indeed, the ability of a rate cut (or increase) to impact CPI inflation itself is not clearly established. It is estimated that a rate cut impacts the economy only after 12–18 months. Thus, the last rate cut of August 2017 should have increased inflation in the last few months. However, inflation has actually come down—that too, sharply, in the past six months.

An interesting aspect of the current monetary policy environment is that inflation is falling consistently below projections. The August 2018 policy review projected inflation to be 4.8% in H2 FY’19. The projection came down to 3.9–4.5% in October 2018 policy and 2.7–3.2% in December review: over 2 percentage point correction in just four months!

Against the projections, actual inflation has come to be 2.6% in the third quarter (Oct.–December, 2018); and is expected to remain at this level during Jan.–March, 2019 also. The current low inflation trend may give hope that this would be the beginning of a benign rate environment. However, it is difficult to visualize that, considering the existing pressure on core inflation and the uncertainty around both food & fuel prices.