MPC should pay more heed to core inflation, says Ashima Goyal

MPC should pay more heed to core inflation, says Ashima Goyal



The Monetary Policy Committee needs to give more importance to core inflation as this component of the consumer price gauge has the largest impact on household inflation expectations, Ashima Goyal, a member of the rate-setting panel, said to ET’s Bhaskar Dutta.

Core inflation strips out the volatile components of food and fuel and attempts to capture underlying demand conditions in the economy. Goyal, whose term at the MPC, comes to an end in early October, also said that the rate-setting panel’s ambit should be widened to provide guidance on liquidity conditions in the banking system.

At present, the MPC decides on interest rates and the stance of monetary policy, while the Reserve Bank of India decides on liquidity management.

Edited excerpts:
Q: Your term at the MPC has witnessed an unprecedented combination of shocks. How did the structures of monetary policymaking hold up to these challenges and could there be any improvements?
A: Inflation targeting has delivered even in a period of multiple adverse shocks. Flexible implementation according to the needs of the domestic cycle and good coordination with the government was essential for this. Countercyclical policy helped smooth shocks. The repo rate cuts during the pandemic were as essential as was the sharp rise when inflation proved persistent after the Ukraine war. Since inflation fell despite recurrent supply shocks with a real repo rate around unity it is clear that a high real repo is not required for credibility of inflation targeting. It is sufficient if the policy rate rises with persistent inflation—indicating there will be action against it. These lessons should be internalized.Headline should remain the target since it affects the public, but the MPC should pay more attention to core inflation. Forecasts of core inflation should also be made public. Research shows that in India causality is from core to headline and in the longer term core has the largest impact on household inflation expectations. So being explicit about these interactions would help anchor expectations and increase understanding of the inflation process. Even trend food inflation guided by MSP changes should not be higher than the target. At present there is too much focus on individual volatile commodity prices. Formalizing government responsibility to reduce such price spikes may induce better productivity enhancing and market developing interventions.The MPC should also give guidance on liquidity, as happens in advanced economies, so that the operating target does not differ for long from the repo rate it sets..Q:You mention in the latest MPC minutes that average Indian inflation is lower and trending down. What are the structural changes that have resulted in this?
A: We have had an inflation target of 4% for a decade now and inflation has been lower than its historical values during this period. Lower expected values of inflation must be slowly getting internalized in all kinds of pricing and wage setting in the economy. Also as the economy grows in scale and diversity, relative price shocks have less of an impact on aggregate prices. The government is also acting more aggressively against supply shocks. Non-inflationary growth in India requires effective supply-side action.

Q: You have flagged the risk of excessive monetary tightening triggering a switch to a lower growth path. Is there a risk to the MPC’s 7.2% growth forecast for the year, especially if interest rates are not lowered anytime soon?
A: Yes, unless the softening in Q1 is reversed. But expected growth has already reduced this year from 8.2% last year. Even if we do grow at 7.2% it would be below our potential.

Q: You have highlighted the importance of shifting from interventions that distort resource allocations to those that boost agricultural productivity. Could you elucidate on the interventions you are referring to?
A: We all know how free electricity and MSPs for select cereal crops have distorted resource allocation in Punjab. India’s food security system is expensive and becoming outdated as cereals no longer dominate food baskets. To prevent the recent kind of spikes in vegetable prices requires use of agritech, diversification in agricultural production and in supply chains. Food supply has to be made resistant to climate shocks.

Q: In two separate points in the minutes, you have alluded to social and political instability, depending on how different social groups are affected by interest rates. Do you feel that there is a need for monetary policy to be more flexible to achieve the true purpose of the Flexible Inflation Targeting regime?
A: Yes, the social contract that has delivered in the post pandemic period is for the MPC to hold the real repo rate at the minimum level that anchors inflation expectations, even as the government acts to lower inflation from the supply side. This allows growth to rise to the highest possible non-inflationary level and more to participate in economic development. Without such inclusive growth the redistributive agendas that held India back for so long will resurface and hurt its development prospects.

Q: You have mentioned the importance of adequate liquidity in the banking system as well as the need for prudential policies that create good incentives for the financial sector. Could you elucidate?
A: If countercyclical prudential policies can be used to reduce credit growth in sectors where it is excessive, it is not necessary to raise repo rates or tighten liquidity that will reduce credit demand even in areas where growth is needed. An example is higher risk weights reducing credit card loans while overall credit growth remains healthy. The requirement of strong balance sheets and good capital adequacy moderates risk-taking and possible systemic spillovers. Financial stability is necessary for growth to sustain.

Q: You have pointed out that India’s post -pandemic growth has exceeded expectations of a return to low growth while saying that something is different now. What is India’s potential growth?
A: Last year core inflation fell below target even with 8% growth, suggesting we can grow at this rate without raising inflation. If demand exceeds supply inflation should rise. Therefore if inflation stays near the inflation target, a demand stimulus can safely be given to raise growth to potential.



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