The 25 bps rate cut decision made by the new policy governing entity – the Monetary Policy Committee half of whose members are appointed by the Finance Ministry was keenly watched.
There is a tendency to interpret the rate cut as the voice of the Ministry though all the six members agreed for the cut as per the RBI communique.
The leading question is whether the changed institutional format for determining monetary policy decisions played its role in making the rate cut.
Or clearly, whether the decision was caused by the MPC or whether the rate cut was taken in the context of economic situation especially inflationary scenario in the country.
An in-depth analysis can reveal that 60% of factors are supportive of rate cut. CPI inflation rate came down by more than hundred basis points in August though inflation was going up during the previous months.
There is one caution for the cut, that the present fall in inflation was caused by base effect. But the RBI while overcoming the base effect question argued that its expectation about future inflation is that food prices may come down.
The steep fall in inflation during August 2016 could have compelled persons like YV Reddy, Subbarao or Raghuram Rajan for making the rate cut.
The MPC, given its pro-growth mindset has got an opportunistic favorable factor while making the decision. The institution is ready for sacrificing little bit of price stability to reap growth is well understood. But the present situation doesn’t give us a chance to test the mindset of MPC to check how far it is ready to embrace inflation to stimulate growth.
At the same time, the decision reveals one side of the character of MPC. Even when the current inflation (5%) is away from the target rate of 4%, the body may go for a rate cut. This reveals its growth bias in policy setting and an indicator for the future management of monetary policy.
How far inflation scenario supported the present rate cut?
August was the month where retail inflation came down by more than hundred basis point vis a vis the previous year.
The consumer price index (CPI) inflation rate, came down to 5.05% in August 2016 after surging for four-straight months, because of reduce food prices. During the previous year consumer price index stood at 6.07% in July led by continuous rise in food prices.
This means that what propelled the low inflation trend in the previous month was the base effect of low inflation in the base period. A high inflation during the base period may make the current inflation low is the net result of the base effect. This is why the August inflation fell by an unprecedented 100 bps.
The new monetary policy statement also recognizes this base effect.
“In August, however, the momentum of food inflation turned negative and surprised expectations; consequently, base effects in that month came into full play and pulled down headline inflation to an intra-year low.”
The fall in inflation during august 2016 came after four month’s consecutive rise in CPI.
Now the question is whether such a base effect warrants a rate cut from the pure monetary policy angle. On this the RBI defended that it expects further ease in food inflation in the coming months. For it, expectations about fall in food prices had “opened up space for policy action.”
Now the future low food inflation prospects have driven the current rate cut. Here, responsibility is big in front of the government to avert any food price shock. Credibility of the present decision rest on low food price realization.