As the Indian economy is beset with an ennui of receding real household income, feeble demand, diminishing corporate profits and an imminent resurge of global protectionism, the recent policy prognosis is of a transient slowdown below the perceived 7 per cent-plus potential real GDP growth.
Amid the fiscal logjam, characterised by government spending cutbacks, a paltry concession of ₹1 trillion in income tax incidence and the RBI’s acquiescence in initiating rate easing are seen as the necessary steroids. The anticipation is that India’s growth car will speed up again in a few quarters.
Are such expectations realistic? We think the likelihood of belied expectations looms as the central bank appears to be working with an outmoded compass amid a tempest.
The Lucas critique that “The past may not be a robust guide to the future”, cited in the Expert Committee report on flexible inflation target framework (2014), a crucial input for RBI’s monetary policy council appears to have faded into oblivion.
The current policy administration is benchmarked to an inflation target of 4 per cent (π*), with a range of 2-6 per cent along with a potential real GDP growth of 7 per cent-plus and a neutral real interest rate (r*) of 1.4-1.9 per cent. These imply a neutral nominal policy rate of 5.4-5.9 per cent (i*=r*+ϖ*). Hence, the 6.5 per cent policy rate till recently and the current level of 6.25 per cent are seen as restrictive. Indeed, the peeve from the government has been that RBI’s stance has been “very stressful” and is responsible for the current growth drag.
Neutral policy
The neutral policy rates (r* or i*) are associated with macroeconomic equilibrium characterising an economy operating at full capacity (or potential growth) without generating inflation beyond the desired level (π*). The current inflation target (π* = 4 per cent) is set with an upper bound defined by the detrimental level of inflation beyond which it is inimically harmful to the economy. The lower end of the range is defined by the level which should be avoided for a deflationary bias, which is also detrimental to the economy. The neutral policy rate and the desirable inflation target, together, create an incentive structure beneficial to both the producers and consumers, thereby consistent with a long-term economic growth potential. The economy operating at an optimal level implies zero or close to zero savings-investment gap, external balances and fiscal deficit.
While the estimates for desirable inflation had been at work since the mid-1980s, the inflation target (π*) of 4 per cent with a flexible range was adopted in 2016 based on the Expert Committee report (2014). Accordingly, 6.2 per cent was seen as the detrimental level which formed the basis for the upper bound of 6 per cent. The 4 per cent desirable inflation target with a two-year horizon was mapped to various past studies on the estimated threshold inflation. The latest estimate contextualises the historical averages during 4Q2003-2Q2006, with GDP growth averaging at 7.5 per cent, corresponding with the current account deficit averaging close to zero (0.4 per cent of GDP) and a merchandise trade deficit of 3 per cent of GDP. The lower bound of 2 per cent was equated to the median of policy rates of advanced economies. The band of 2 percentage points around the 4 per cent target inflation is wide but it allowed for the volatility of food prices, which dominated the CPI calculation.
The success or appropriateness of monetary policy, hence, should be measured against the macro characteristics rather than on just the estimated desired inflation target of 4 per cent as over the past two decades, significant structural changes may have rendered the estimates obsolete.
In disequilibrium
Against this framework, the current macro variables are clearly in disequilibrium; inflation has consistently been above target, eight-quarter average CAD and trade deficit stands at 1.3 per cent and 7 per cent of GDP respectively, REER is overvalued, private capex revival remains elusive since 2012, and non-cyclical savings rate has been declining since then. These are symptomatic of declining productivity and potential growth and resonate with rising disguised unemployment and dependence of workers on rural and agriculture occupations.
Real wages have consistently decelerated over the past decade and contracted over the past five years, household incomes have been stressed, and real consumption has decelerated to just 3.1 per cent since 2011-12 (HCES 2023-24). Tightening household income constraints have resulted in a peak level of household indebtedness. And, as the governments backfilled for the persistent lack of private capex, public debt has skyrocketed to ₹270 trillion (FY25E), leading to the crowd-out effect of excessive tax incidence on households. The large government capex over the recent years has not demonstrated the expected multiplier or crowd-in effects for the broader economy.
The decline in CPI inflation to 4.3 per cent in January 2025 from 6.2 per cent in October 2024 due to the seasonal decline in vegetable prices is extrapolated to predict a victory over inflation soon. However, the medium-to-long-term performance shows that RBI’s inflation-targeting objective is less convincing. Over the past 24 months, inflation has averaged 1.25 per cent above the 4 per cent target and the de-facto one standard deviation range has been +/-1 per cent around 5.25 per cent. In 59 out of the 61 months since January 2020, inflation has remained higher than the target. The records since 2012 are not very different either.
Additionally, in the changed structural context, the actual inflation, ranging mostly between 4 per cent and 6 per cent and around a median of 5 per cent, has been inimical to economic growth, and overall productivity.
Implications for monetary policy
These inferences lead us to important implications for monetary policy assumptions:
Potential GDP growth is significantly less than the 7 per cent assumption, closer to real household income growth of 3.5-4 per cent, which comprises nearly 80 per cent of GDP.
The current inflation target of 4 per cent associated with two-decade-old macro averages is outdated, necessitating a reset of estimate.
Given the contraction in real wages (PLFS) and household income buffered by rising labour participation in unproductive occupations, the desirable inflation (π*) should be less than 4 per cent; a 3 per cent level may be appropriate.
The real neutral rate (r*) of 1.4-1.9 per cent estimated in RBI’s recent study is higher than the actual average of 1.1 per cent since November 2022. The current levels are also lower than the pre-pandemic average of 2.2 per cent. Given the trend decline in structural components of the saving rate, average inflation of 5 per cent and the inflation target of 4 per cent remain inimical. Further, global capital flows are getting restrained amid rising protectionism. Thus, the desirable r* should be above 2 per cent.
Assuming desirable r* at 2.0-2.25 per cent and the current average inflation rate around 5 per cent the nominal policy rate works out to be closer to 7 per cent, thereby rendering the 6.25 per cent rate accommodative as the inflation gap works out to 2 per cent over the proposed 3 per cent new inflation target.
Summing up, the common perception that RBI has been restrictive is misplaced. If our assessment of the structural shift in macro conditions is correct, then the outmoded monetary policy compass may have aggravated the macro disequilibrium by being overly accommodative. Not only has the real rate persisted below our presumption of r* at 2.0-2.25 per cent, the RBI has also ensured liquidity in the system remaining comfortable over the last 8.5 years; 78 per cent of the last 200 fortnights have seen surplus balances under RBI’s Liquidity Adjustment Facility (LAF), despite the persistent paucity of deposit mobilisation. Adopting an inflexible exchange rate regime over the past two years was also geared towards ensuring a favourable domestic market situation.
Consequently, the accommodative financial conditions may have led to a situation of spiralling asset bubbles, eminently in the real estate and equity markets. The ₹76 trillion erosion in market capitalisation in Indian equities over the past six months, equivalent to 30 per cent of annual aggregate household income, is a manifestation of overvaluation and can potentially lead to a contagion effect, risking financial instability. The RBI’s capitulation to demands for easing may be an attempt to prevent a full-blown bust, but with an outmoded compass, the likelihood of going further astray can increase.
The writer is Head of Research – Strategy & Economics, Systematix Institutional Equities