05/10/2016 5:15 PM IST | Updated 05/10/2016 6:44 PM IST

Urjit Patel's Signal Of Looser Inflation Tolerance Has Economists Scratching Heads

"The RBI has shifted from a one man rock star to more like a choir with ensemble of singers"

Bloomberg via Getty Images

Indian central bank chief Urjit Patel has signaled a looser tolerance for inflation that's set economists scrambling to rework their interest-rate forecasts.

While Patel as a Reserve Bank deputy governor backed a plan to temper inflation to 4 percent by March 2018, he declined to restate that Tuesday in his first policy decision since taking the helm. The takeaway for analysts at banks including Nomura Holdings Inc. and Morgan Stanley: he's now content to let prices rise as much as 6 percent, the upper limit to the RBI's band.

In a second signal of a shift, Michael Patra, a career RBI official who's a member of the six-person panel that now decides on policy, cited Tuesday a pared-back estimate of the medium-term desired rate of return for savers. Former Governor Raghuram Rajan had said a 1.5 to 2 percent inflation-adjusted rate was reasonable. Patra suggested the level could instead be around 1.25 percent.

Along with the rate cut that came as a surprise to most economists this week, the signals suggest that the new Monetary Policy Committee is prepared to accept faster inflation and is more focused on growth. That risks worsening what's already the biggest price pressures in Asia, undercutting the purchasing power of millions of low-income households.

Changing Call

"The rate cut was justified not on the basis of an inflation undershoot, but by tweaking the framework" for policy, Sonal Varma, chief India economist at Nomura, and her colleagues wrote in a note. "We are changing our policy call. However, we do not believe that easing is justified on economic grounds."

Alpana Killawala, the RBI's spokeswoman, didn't immediately respond to an e-mail seeking comment on the signal of a lower inflation-adjusted return for savers.

Most economists surveyed by Bloomberg last month had anticipated a quarter-point cut in the policy rate by the end of December, with the rate staying at that level through next year. Most, however, had expected the MPC to hold off this week.

Now, Nomura sees an additional reduction, to 6 percent, as soon as December -- though more likely in February. ICICI Bank Ltd. and Capital Economics forecast 6 percent by March, while Morgan Stanley predicts a move to as low as 5.75 percent by then.

Backfire Danger

"That's a break from the more hawkish stance of the previous governor, Mr. Rajan, which helped restore the RBI's credibility," said Shilan Shah, a Singapore-based economist at Capital Economics. "We fear it could backfire, and that the RBI will be forced to reverse course and hike rates in 2017."

Rajan had taken charge of the now 81-year-old Reserve Bank of India in 2013, when the rupee was at a record low against the dollar. In his first public speech as governor, he vowed to sustain confidence in the currency by keeping inflation low and stable and, in his final address, he urged his successor to stick to that path.

Rajan had also left his successor armed with an inflation target and the MPC, which was designed partly to help deflect criticism from the government, which has historically sought lower borrowing rates.

"The RBI has shifted from a one man rock star to more like a choir with ensemble of singers," Sean Yokota, Singapore-based head of strategy at SEB AB, wrote in a report. "Patel's style and new MPC framework are expected to be an improvement with more transparency but when inflation pressures rise, they may have a more difficult time standing tall to a pro-growth government."

By lowering borrowing costs this week without lowering its expectations for inflation or growth, the RBI signaled a new framework for policymaking. The central bank still sees the world's fastest-growing economy picking up speed, with inflation risks remaining to the upside. Those risks stem from pay rises for civil servants, and even uncertainty around the U.S. elections, the RBI said in a report Tuesday. A jump in market volatility after the U.S. presidential vote that weakens the rupee could boost inflation, it said.

Consumer prices gained 5.05 percent in August, after breaching 6 percent the previous month. The RBI's research department on Tuesday said the rate will stay at 5 percent through 2016, accelerate to 5.3 percent by March and dip to 4.5 percent a year later.

"This may mean a new era wherein the RBI may be more amenable to higher inflation threshold than we believed to be the case earlier," said Kunal Kundu, an economist at Societe Generale SA. While Kundu currently predicts the RBI to hold rates until the end of 2017, he said he'd watch for statements that indicate Patel is willing to further drop the ceiling on real rates as he considers his forecasts for monetary policy.