As per the latest MPC minutes, you said it is important that the real repo rate does not rise too high. As inflation slows, what constitutes too high a real rate?
A real repo rate above 1.5% would be too high given the global slowdown and other growth vulnerabilities. Since there are no signs of excess demand, a real repo rate around 1% should be adequate to bring inflation towards the target.
Given that real rates are near equilibrium levels, at what point would you consider accommodation to have been sufficiently withdrawn?
If inflation forecasts fall sustainably below 5%, there would be no need to further withdraw accommodation.
In a stance of withdrawal, where should banking system liquidity ideally be?In my view, banking liquidity should be maintained sufficiently in surplus so that shocks do not cause short rates to spike above the repo rate.RBI surveys show firms expecting price and cost inflation to rise despite actual softening. Do you see a risk from the perspective of inflation expectations?
Expectations are not rational, that is, actual inflation is not correctly foreseen. The risk is if firms actually raise prices based on these expectations and core inflation firms up. But firms’ input costs have fallen, and profit margins have risen. Passing through cost decreases is a good strategy since demand is slack and the Indian consumer is price sensitive. So, core inflation should soften further in the absence of further persistent supply shocks. Falling core inflation is necessary to sustainably reach the target, so we need to watch and make sure those expectations are not realised.
You spoke of the greater impact of official communication in emerging markets when it comes to bringing inflation to target…
There is more awareness of the inflation target, and that policy reacts as necessary to achieve it. Communication must emphasise that 4% target now that growth shows some resilience. There is a misperception that the MPC is happy with 5% inflation. Higher inflation was tolerated only to protect growth because of the major shocks of the past few years. An inflation targeting regime where the nominal repo rate responds to expected inflation to ensure appropriate real repo rates is adequate to credibly anchor inflation expectations. An appropriate real repo rate is required, not a ‘high nominal repo rate’. It is the real repo rate that affects demand. So, if expected/forecasted inflation falls sustainably, the nominal repo rate should fall with it, preventing an excessive real repo rate rise.
Is there room for the MPC to diverge from central bank actions in developed markets?
Yes, the nominal interest differential with advanced economies can be lower to the extent the inflation differential falls. Higher growth prospects, a more diversified economy and a more robust external sector also reduce country risk premium. There is room not only to diverge from developed market central bank actions but also to protect the economy from spill-overs arising from these actions.