This article by Urjit Patel elaborates on the recent actions of the RBI which are likely to result in making the role of MPC redundant. Some of the moves cited are injection of liquidity by the RBI and reduction of reverse repo rate by the RBI. Implications such actions could have for the macroeconomic stability are also discussed.

Stimulus package after the 2008 financial crisis and problems created by it

• Following the global financial crisis of 2007-08, India, like many other countries, embarked on a stimulus.
• The pump-priming did not end too well.
• Inflation and bad loans: By 2013, India crossed or approached double-digit figures in inflation and the national fiscal deficit, in addition to looming bad loans.
• Taper tantrum: In summer 2013, when the Federal Reserve indicated a possible reversal of its ultra-accommodative policy, macroeconomic parameters for India were so weak that it got caught up in the “taper tantrum” and experienced external sector fragility.

Inflation targeting and the role of MPC

• While fiscal excesses and financial sector stress remain issues today, India has improved significantly on at least one dimension — namely, inflation — which has also stabilised the external sector.
• How was this beneficial progress achieved?
• Starting in September 2013, the Reserve Bank of India (RBI) initiated an effort to build credibility with domestic savers and international investors on maintaining inflation at prudent levels.
• Three years thereafter, the RBI Act was amended to put in place a flexible inflation targeting framework.
• A Monetary Policy Committee (MPC), comprising of RBI representatives and external members appointed by the Government of India, was enjoined with the legal mandate of managing the policy (repo) rate.
• MPC was mandated to keep consumer price inflation at a target level of 4 per cent, while keeping in mind economic growth.

Assessment of MPC’s performance

• By objective measures, the MPC framework until recently worked rather well.
• It lent transparency and democratic accountability to the process of interest-rate setting.
• Combined with efforts on managing food inflation, it has brought inflation closer to the target.
• It has contributed to tempering household inflation expectations.
• It has kept borrowing costs in the economy at reasonable levels in spite of the high level of government borrowing and several other distortions.
• Appreciation by the rating agencies: Indeed, rating agencies and multilateral institutions repeatedly mention the MPC and the inflation targeting framework as a landmark structural reform towards sound macroeconomic management.

Latest monetary actions by RBI that reduced MPC’s role

• Since last year, a series of monetary actions by the RBI have left the MPC’s decision on the policy rate partly redundant, diluted the accountable process of monetary decision-making.
• This has put at stake the sanctity of the MPC framework.
• With a stated intention to improve the transmission of monetary policy to households and corporations, the RBI has pumped unprecedented levels of money (close to Rs 7 trillion) into the banking system.
• It has done so mostly by purchasing government bonds but partly also by purchasing dollars.
• No desired results: Given impaired financial sector balance-sheets, transmission to economic growth has been at best muted; liquidity is no silver bullet to durably address financial sector stress.
• The primary effect of excessive liquidity has, instead, been to monetise the government’s expenditures and keep its borrowing costs low.
• With its declared aim not being met satisfactorily, the RBI has doubled down on liquidity supply, with the same outcome.
• An important casualty has been the MPC framework.
• Contradictory actions: At times, even when the MPC has kept the policy rate unchanged, the RBI has injected yet more liquidity to move medium-term interest rates down.
• The two actions have been noted to be in direct contradiction of each other.
• If the objective is to move medium-term rates, why not build consensus within the MPC to cut the policy rate more aggressively and communicate the rationale?
• Change in reverse repo by the RBI: Further, given the enormous liquidity glut, every night banks park liquidity with the RBI at a (reverse repo) rate lower than the policy rate and which is not set by the MPC; nevertheless, this rate used to be changed only as part of the MPC Resolution.
• Lately, the RBI has moved reverse repo rate progressively lower than the policy rate; recently.
• It has done so outside of the MPC meeting cycle and not as part of the MPC Resolution.
• There are straightforward tools in liquidity management to ensure that in surplus conditions also, the central bank transacts with banks at the policy rate — technically, by switching from “deficit” to “floor” system of liquidity management.
• Such a switch is routinely adopted by central banks when they provide excess liquidity; the RBI has chosen not to do so.

What are the implications?

• The net effect is that market interest rates are being increasingly controlled by the RBI rather than the MPC.
• Indeed, there is a proposal that the rate at which the RBI absorbs liquidity be still lower, likely divorced from the policy rate set by the MPC.
• The spirit of the MPC framework enshrined in the RBI Act is being violated.
• It is unclear how the MPC can be expected to satisfy its legal mandate if what it seeks to achieve via the setting of the policy rate is in conflict with, or compromised by, the RBI’s liquidity management.
• These developments have the potential to pose risks for India’s macroeconomic stability going forward.
• The implicit monetisation of fiscal expenditures through government bond purchases by the RBI in the secondary market has postponed the recognition of the untenable fiscal reality.
• The delay has meant the government has had limited policy space since the onset of COVID.
• Supply-chain disruptions due to measures taken to contain the pandemic raise the possibility of cost-push inflationary pressures, especially given the excessively easy fiscal and monetary conditions.
• This can abruptly raise economy-wide borrowing rates, inflict losses on banks, and imperil financial stability.
• If the gains in inflation credibility built by the MPC framework are dissipated by ineffective policies and operations, both household and investor expectations for inflation in India could unhinge.
• Worse, it could instigate turmoil in the external sector.
• Excessively low bank deposit rates may induce some non-resident deposits to exit the country.

A question based on the issue of RBI’s action and its implication for MPC and overall economy can be asked by the UPSC, for ex- “The MPC framework has performed well in delivering on its mandate. Yet, there were some actions by the RBI recently which could be perceived as inimical to the functions of the MPC. Discuss.”

Conclusion

In a highly unpredictable time such as this, the RBI should preserve its inflation credibility. The decision on monetary policy actions based on voting by committee members, provision of inflation and growth forecasts in the resolution statement, and coordination of rate-setting and liquidity management, need to be adhered to.

Back2Basics: What is MPC?

• The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016,  to provide for a statutory and institutionalised framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth.
• The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.
• The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.
• As per the provisions of the RBI Act, out of the six Members of Monetary Policy Committee, three Members are from the RBI and the other three Members of MPC are appointed by the Central Government.
• Governor of the RBI is ex officio Chairman of the committee.

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