The policy statement of the first bimonthly Monetary Policy Committee (MPC) meeting opted for a neutral policy stance. A neutral policy stance means that the RBI is keeping the policy rate (repo rate) unchanged, indicating that the RBI believes that in the near future there is going to be no demand pressure neither any supply bottlenecks in the Indian economy. Repo rate is the rate at which the Central Bank, in this case the RBI, lends money to the commercial banks, and is used to control inflation.
The primary purpose of RBI is to promote growth and restrict inflation in India. This neutral policy is being seen by many as a step towards bringing down the long term inflation rate, which would be more supportive of growth. This decision is best exemplified for undergraduate students through deliberation of the framework of Neo Keynesian (NK) macroeconomic theory.
The NK framework, which is an extension of the Aggregate Demand & Aggregate Supply framework, helps us understand the rise and fall of inflation rates and how equilibrium can be attained (even though theoretical). In the short-run, macroeconomic equilibrium occurs when the quantity of GDP demanded equals the quantity supplied, thus maintaining a neutral repo rate indicates the real economic situation where RBI is conscious of inflation risk and uncertain global trade environment.
In order to help us in understanding what would be the consequences of a neutral repo rate, let us understand the NK framework in details. The first component of NK is the IS curve which aims to exhibit a positive relation between interest rate and unemployment, whereas the second component, Philips Curve exhibits a negative relation between unemployment and inflation. Combining these two aspects, the model is closed through Taylor’s policy rules, which acts as a guide for the central bank to manage money, credit, and interest rates in the economy to achieve its economic goals.
In the present economy, a neutral repo rate maintains level of consumption and also ensures the demand in the economy by making savings as attractive as consumption or investment, which would tend to lower inflation in future. From the point of view of the stock market, neutralisation of interest rate does not boost asset prices like housing prices, equity prices, and equity indices exponentially, as it also maintains the borrowing cost. In the long run, there is an expected boost of corporate wealth and improved cash flows, helping in reinforcing the aggregate demand in the economy.
In order to help us develop an understanding of the neutral stance and how it affects the real life economy, let’s take a look at Indian economy data over the last few months. From the demand side of the economy, CSO’s (Central Statistics Office) advanced estimate shows that the real GDP of India has marginally increased to 6.6 % from 6.5 %. This increase in GDP signifies increase in private consumption on the back of strong growth in the domestic aviation sector and consumer durables. Investment demand, evident from the growth in capital goods production has also increased as is and registered a yearly high in January, 2018. This growth in demand is well counteracted by the supply side of the Indian economy.
If we look at the inflation data, retail inflation has decreased to 4.4 % from 5.1 %, headline inflation is 4.1 % and Consumer Price Index (CPI) inflation is stable at 5.2 %, which are all well under the inflation targeting band of 4 ± 2 % band of RBI. The data vindicates RBI’s stance of a neutral monetary policy. If we look at the supply side data of the Indian economy, the advanced estimates in the agricultural sector tell us that production is going to increase by 0.9 %. The manufacturing Purchaser Manager’s Index (PMI), which shows the health of the manufacturing sector, was in a constant expansionary mode for the past eight months. The RBI’s Industrial Outlook Survey (IOS) also shows positive business sentiment for the manufacturing sector.
This neutral monetary policy thus help us conclude the stable state of the Indian economy at this moment with no major demand side pressure or supply side bottleneck. Inflation also seems to be stabilised within the band of inflation targeting for RBI, thus ensuring the monetary policy decision to be no surprise.