Context

Communication is a critical element of monetary policy. Yet there seems to be a gap between what the MPC says and what the RBI does.

About MPC

• The Reserve Bank of India Act, 1934 (RBI Act) has been 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.
• Highest monetary policy-making body: By law, the Monetary Policy Committee is the highest monetary policy-making body in the land, tasked with deciding monetary policy changes at regular intervals.
• Composition: The MPC will have six members – the RBI Governor (Chairperson), the RBI Deputy Governor in charge of monetary policy, one official nominated by the RBI Board and the remaining three members would represent the Government of India.
• The MPC will be chaired by the Governor.
• Under the inflation targeting regime, the most important role in communication belongs to the MPC.

Communication with public

• Monetary policy changes are communicated through formal statements, with the discussions underlying these decisions also being published, so that the public can understand why the MPC decided the way that they did.
• Communication gap: Over the past few years, a communication gap seems to have opened up between what the MPC has been saying and what the RBI has been doing, thereby potentially eroding the credibility of the IT framework.
• Influencing inflation expectations: Communication is an important part of the ability of the central bank to influence inflation expectations. 

Following are the ways which indicate the communication gap between the RBI and the MPC, with several implications for the credibility of the MPC.

1] Separate statements

• During the first few years of the inflation-targeting regime from 2016 to 2018, the process of communication worked quite well.
• On the days of policy announcements, the governor and his deputies would participate in a press conference.
• From 2019 onwards, however, things began to change.
• Governor’s separate statement: The RBI began to release a separate governor’s statement on the day of the monetary policy meeting, presenting an inflation outlook and even explaining the decision taken by the MPC.
• MPC statement: It has overlapped with the MPC statement; at times, it has seemed somewhat different.
• For example, following the June 8 Monetary Policy Review the MPC highlighted inflation concerns, and voted in favour of raising the policy repo rate.
• On the same day, a governor’s statement mentioned that the central bank will also remain focussed on the orderly completion of the government’s borrowing programme.
• Confusion: The issuance of two such different statements can lead to confusion, especially as lowering inflation and lowering government bond yields are contradictory policy objectives.

Why is communication so crucial? To influence inflation expectations!

• If the public believes the central bank is committed to keeping inflation under control, then it will act accordingly.
• Firms will moderate their price increases, fearing that large price rises will make them uncompetitive.
• Meanwhile, workers will accept moderate wage increases, while investors will accept low interest rates on their bond purchases.
• With everyone acting in this way, it will be easier for the central bank to ensure that inflation indeed remains low.
• Anchored inflation expectations: If inflation expectations are well anchored, then it becomes relatively easy for the central bank to ensure that inflation returns to the target level before too long.

2] Change in the Monetary Policy Corridor width during pandemic

• Deciding the repo rate: The most important task of the MPC, enshrined in the RBI Act (Amended), 2016 that introduced IT, is to decide the repo rate, since this has long been the lynchpin of India’s monetary policy framework.
•  Ever since the early 2000s, policy had aimed to keep overnight money market rates in a corridor, with the lower bound established by the reverse repo rate and the upper bound by the repo rate.
• Since the width of this corridor was fixed, once the repo rate was decided, the reverse repo rate was automatically determined, and market overnight rates adjusted accordingly.
• During the Covid-19 pandemic, the RBI constantly adjusted the reverse repo rate even as the MPC kept the repo rate unchanged.
• As a result, the fixed width of the corridor was lost, and the MPC lost any role in determining interest rates.

3] Introduction of policy instruments outside the remit of MPC

• During pandemic, the RBI introduced a number of new policy instruments, again outside the remit of the MPC.
• GSAP: It brought in the GSAP programme through which it pre-commited to buying a certain amount of dated government bonds in order to control their yields.
• Variable reverse repo auctions: It then introduced variable reverse repo auctions, and more recently, replaced the reverse repo rate with the long-dormant standing deposit facility rate.
• The rationale for this was not explained in the MPC statement.
• All unconventional monetary policy announcements were kept outside the MPC statement.
• This raised the questions about the role of the committee in deciding monetary policy actions at a crucial time like the pandemic.

4] Intervention in the foreign exchange market

• The RBI has been intervening in the foreign exchange market to manage the rupee.
• Forex interventions by definition influence the domestic monetary base and inflation.
• Yet the MPC in its monetary policy statements does not discuss either the exchange rate dynamics or the forex interventions.
• Just as it does not discuss the RBI’s interventions in the bond market to lower the yields.

Way forward

• In its latest two statements, the MPC indicated that policy would now be focusing on bringing India’s inflation rate under control.
• Clear policy framework: If the RBI is going to be successful in this endeavour, the first step must be to close the communication gap, by reintroducing a simple and clear policy framework and restoring the central role of the MPC.

Conclusion

The net result of all these actions is a potential loss of both clarity and credibility. The communication gap will need to be closed in order for the RBI to become successful in bringing inflation back to its 4 per cent target level.

UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

Back2Basics: Monetary Policy Corridor

• The Corridor in the monetary policy of the RBI refers to the area between the reverse repo rate and the MSF rate.
• Reverse repo rate will be the lowest of the policy rates whereas Marginal Standing Facility is something like an upper ceiling with a higher rate than the repo rate.
• The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.
• As per the monetary policy of the RBI, ideally, the call rate should travel within the corridor showing a comfortable liquidity situation in the financial system and economy.

What is GSAP?

• The G-Sec Acquisition Programme (G-SAP) is basically an unconditional and a structured Open Market Operation (OMO), of a much larger scale and size.
• G-SAP is an OMO with a ‘distinct character’.
• The word ‘unconditional’ here connotes that RBI has committed upfront that it will buy G-Secs irrespective of the market sentiment.

Get an IAS/IPS ranker as your 1: 1 personal mentor for UPSC 2024

Attend Now

Context

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) on Friday gave a surprise, with a formal start to policy normalisation. This was contrary to the predominant market expectations of a hold.

RBI on the path of policy normalisation

• Focus on target of 4% +/- 2%: While the MPC voted unanimously to remain accommodative, in a change of language, the focus would now be on “withdrawal of accommodation to ensure that (CPI) inflation remains within the target (of 4 per cent +/- 2 per cent) going forward”.
•  Remember, the RBI had become a (flexible) inflation-targeting central bank since FY17, whose primary objective is price stability, that is, inflation management.
• The Liquidity Adjustment Facility (LAF) corridor was narrowed back to the conventional 0.25 percentage points from the earlier extraordinary pandemic widening in late March 2020.
• The cap of the erstwhile corridor was the repo rate and the floor was the reverse repo.
• Now, while the repo rate was held at 4.0 per cent and the latter at 3.35 per cent, the floor of the corridor was increased by 0.4 percentage points from 3.35 per cent.
• There was also a change in the monetary policy orientation, of which the stance is one component.
• The priority for monetary policy now is inflation, growth and financial stability, in that order.

Reasons for unexpected tightening of policy

• Inflation concerns: Despite uncertainty over growth impulses and demand concentrated at the upper-income level households, inflation has increasingly emerged as a big concern.
•  Given that inflation is likely to average 6.1 per cent in Q4 of FY22, this increases the risk of inflation remaining above the 6 per cent upper target for three consecutive quarters, necessitating an explanation to the government by the MPC.
• One comforting aspect of this scenario is that household inflation expectations remain anchored, with the median of three months to one year ahead expectations (as of March ’22) rising by only 0.1 percentage points from the earlier January readings.
• Stabilisation of demand: On demand conditions, the RBI scaled-down the FY23 real GDP growth projection to 7.2 per cent (from 7.8 per cent), indicating that a combination of continuing supply dislocations, slowing global economy and trade, high prices and financial markets volatility are likely to take a toll.
• One possible reconciliation with modest GDP growth is continuing weakness in services, which is also borne out by channel checks.
• Certainly, continuing high inflation is likely to lead to some demand destruction, which will act as an automatic stabiliser.
• A relatively loose fiscal policy is likely to offset some of this reduced demand, particularly with continuing subsidies to lower-income households.
• Financial stability: This has multiple dimensions – interest and foreign exchange rates, market volatility, banking sector asset stress, and so on.
• An important objective for the RBI is the management of money supply and system liquidity.
• In a rising rate cycle, with a large borrowing programme of the Centre and state governments, interest rates on sovereign bonds are likely to increase without a measure of support from the RBI through Open Market Operations (OMOs).
• This will entail injecting more liquidity into an already large surplus, which might add to inflationary pressures.
• The introduction of the overnight Standing Deposit Facility (SDF) was a significant measure in this context.
• Unlike the reverse repo facility, the RBI will not need to give banks government bonds as collateral against the funds they deposit.
• This is thus a more flexible instrument should a shortage of government bonds in RBI holdings actually transpire under some eventuality, say the need to absorb large capital inflows post a bond index inclusion.

What are the implications?

• Interest rates will begin to increase but, for bank borrowers, this is likely to be a very gradual process.
• For corporates and other wholesale borrowers, who also borrow from bond markets, this increase is likely to be faster as the surplus system liquidity is gradually drained.
• How this is likely to affect demand for credit is uncertain, given the capex push of the government, some revival of private sector investment and likely continuing demand for housing.

Conclusion

This cycle of policy tightening will present a particularly difficult mix of economic and financial trade-offs, but RBI has demonstrated the ability to innovatively use the multiple instruments at its disposal to ensure an orderly transition.

UPSC 2022 countdown has begun! Get your personal guidance plan now! (Click here)

Back2Basics: Liquidity Adjustment Facility corridor

• Liquidity adjustment facility (LAF) is a monetary policy tool which allows banks to borrow money through repurchase agreements or repos.
• LAF is used to aid banks in adjusting the day to day mismatches in liquidity (frictional liquidity deficit/surplus).
• The liquidity adjustment facility corridor is the excess of repo rate over reverse repo.

Get an IAS/IPS ranker as your 1: 1 personal mentor for UPSC 2024

Attend Now

Context

The Monetary Policy Committee of the RBI kept the benchmark policy rates unchanged, and retained the accommodative stance in its October review.

Factors playing part in monetary policy decisions

• It’s important to remember that monetary policy these days is influenced by both local macroeconomic developments and the global monetary policy direction, with the former playing a dominant role.
• Locally, after the second wave of the pandemic, a variety of indicators such as the Purchasing Managers Index (manufacturing and services), mobility indicators, government tax collections, exports and imports are pointing at an improvement in economic activity.
• Then there is the good news on the monsoon front. With a late pick-up in rains, the cumulative deficiency in this monsoon season has come down to just 1 per cent of the long-period average (LPA).
• Since the MPC’s August 2021 policy review, Covid-19 cases have trended down and there has been admirable progress on the vaccination front.
• Also, despite high year-on-year growth numbers, the level of economic activity this fiscal will only be 1.5 per cent above 2019-2020.

Trends emerging from the economic recovery

• Role of government: Capital expenditure of both the Centre and states is on track to meet the budgetary commitment, supported by healthy tax collections.
• Large companies on recovery path: Large companies in industrial sectors such as steel, cement, non-ferrous metals are operating at healthy utilisation levels, and have deleveraged their balance sheets.
• Policy support for smaller companies: The going is not so good for the smaller ones.
• Clearly, smaller companies need policy support. The extension of the Emergency Credit Line Guarantee Scheme is a recognition of that.
• Private consumption is not broad-based either.
• Even in goods consumption, which is faring better than services, the nature of demand seems skewed towards relatively higher-value items such as cars and utility vehicles.
• This probably reflects the income dichotomy spawned by the pandemic.
• Inflation: Its fall to 5.3 per cent in August offers only limited comfort for two reasons.
• One, core and fuel inflation, which have 54 per cent weightage in CPI, remain stubbornly high.
• Second, food prices have nudged down overall inflation.
• Domestic growth-inflation dynamics suggest that the RBI has little option but to remain more tolerant of persistent price pressures, and hope that these will eventually prove transitory because they have been primarily driven by supply shocks caused by the pandemic.

Global monetary policy environment

• Globally, the monetary policy environment is veering towards normalisation/tapering/interest-rate rise largely due to an upward surprise in inflation, or because some central banks feel the objectives of quantitative easing have been met.
• Central banks in advanced economies such as Norway, Korea and New Zealand have recently raised rates.
• The two systemically important central banks — the US Federal Reserve (Fed) and the European Central Bank (ECB) — view the current spike in inflation as fleeting and have communicated greater tolerance for it for a longer period.

Conclusion

The process of mopping up excess liquidity will slowly gain pace over the next few months, followed by a policy rate hike sometime around early 2022. By then, there should be enough clarity on the third wave and the stance of the Fed and the ECB.

UPSC 2022 countdown has begun! Get your personal guidance plan now! (Click here)

Get an IAS/IPS ranker as your 1: 1 personal mentor for UPSC 2024

Attend Now

The article analyses the success of the inflation targeting mechanism in India and its impact on the growth of the economy.

Background of the inflation targeting policy in India

• It has been three decades since inflation targeting was first adopted in New Zealand and subsequently by 33 other countries.
• India adopted it in 2016.
• The primary goal of inflation targeting was to contain inflation at around 4 per cent, within the allowable range of 2 to 6 per cent.
• The RBI has announced a formal review of the policy instrument now.
• At the first meeting of the RBI Monetary Policy Committee in October 2016, it was also formally announced that the MPC considered a real repo rate of 1.25 per cent as the neutral real policy rate for the Indian economy.
• By a neutral real policy rate, the RBI meant a policy rate consistent with growth at potential (i.e. growth at full employment).

Has inflation targeting worked in India

• The evaluation of IT must provide answers to the following two questions:
• Did inflation decline post the adoption of inflation targeting and what was the role of IT in the decline in inflation?
• Was the adoption of inflation targeting associated with the policy of the highest real repo rates in India — ever — for almost three years 2017-2019?
• The answer is yes to the latter, but it also needs to be acknowledged that high real repo rates were the primary cause of the GDP growth decline in India from 8 per cent to 5 per cent.

Need to take into account the global context of inflation

• An interesting feature of the Indian defence of inflation targeting is that very few take into account the global context of inflation in which the decline in inflation has occurred in India.
• A research paper by Balasubramanian, Bhalla, Bhasin and Loungani at ORF evaluates inflation targeting in a global context and separately for Advanced Economies (AEs) and Emerging Economies (EES).
• Some facts from the paper are the following.
• First, the annual median inflation in AEs has been consistently low, so low that many central banks have official campaigns to raise the inflation rate.
• One conclusion might be that IT succeeded beyond anyone’s dreams in these economies.
• But attributing this decline in inflation to IT would be erroneous.
• Inflation is global and price-taking by millions of producers in the world means that no one producer or one country can influence the price of any item.
• Oil has ceased to be a factor in global inflation, at least post the mid-1980s.
• The lowest inflation in Indian history occurred during 1999-2005, averaged only 3.9 per cent.
• The average median rate among EM targetters during 2000-04 was 4 per cent, and among the non-targeting countries was 3.8 per cent.

Did fiscal deficit play role in inflation targeting

• In 2003, India passed the FRBM act to control fiscal deficits and inflation.
• There is precious little evidence, either domestically or internationally, about fiscal deficits affecting inflation.
• For three consecutive years preceding the FRBM announcement, the consolidated Centre plus state deficits registered 10.9 per cent(in 2001), 10.4 and 10.9 per cent.
• For the seven-year 1999-2005 period, consolidated fiscal deficits averaged 9.4 per cent of GDP.
• Yet, that these years represented the golden period of Indian inflation — without FRBM and without IT.

Cost of inflation targeting in India

• There are also costs to inflation targeting in India.
• It led to higher real policy rates, in the mistaken belief that high policy rates affect the price of food, oil, or anything else.
• But high real rates affect economic growth, by affecting the cost of domestic capital in this ultra-competitive world.
• It is very likely not a coincidence that potential GDP growth, as acknowledged by RBI, was reached just before the MPC took over decision making in September 2016. 
•  Since then there was a steady increase in real policy rates, and a steady decline in GDP growth.

Consider the question “How far has the inflation targeting mechanism been successful in India? Give reasons in support of your argument.” 

Conclusion

So, in the inflation targeting mechanism has not been successful in containing the inflation though there had a cost associated with it which we paid in the form of growth.

Get an IAS/IPS ranker as your 1: 1 personal mentor for UPSC 2024

Attend Now