Key messages and issues from Governor Rajan’s Bi-monthly Monetary Policy Statement released on April 1, 2014

April 16, 2014

RBI Watch                                                                                      Monetary Policy 2014-15                                                                                                                                    

Key messages and issues from Governor Rajan’s Bi-monthly Monetary Policy Statement released on April 1, 2014, his press statement, and Team Rajan’s post-statement conference calls with press and analysts

The bi-monthly statement is not just about monetary policy but also about RBI’s take on and initiatives covering the financial sector. Part B is devoted to developmental and regulatory policies and is just as lengthy as Part A, which covers monetary policy.

The future path of monetary policy…

There is no change in the monetary policy stance of the RBI. The operating tool of monetary policy, the repo rate, remains at 8%.

The long term path is to hit 8% CPI inflation (CPI is the target not WPI, anymore) by January 2015 and 6% by January 2016.

In terms of the operating tool of monetary policy, there is now greater emphasis on term repos as compared to overnight repos. This is said to improve the transmission mechanism of monetary policy.

Rajan indicates that if inflation does move along the intended path then “further policy tightening in in the near term is not anticipated at this juncture”.

This begs the question: will RBI loosen monetary policy? Rajan’s statement implies that he has kept both options – continuing with the same stance or loosening monetary policy.

Will RBI follow a real policy (interest rate) rule?

One of the weaknesses of monetary policy between 2008 and 2013 was that the RBI had not kept real interest rates positive when inflation was well above the comfort level. The Urjit Patel Committee refers to this issue (page 37), and suggests that real interest rates should be kept positive to bring inflation down to the desired level. So does this mean that RBI will favour keeping the current monetary stance if inflation trends below 8% by January 2015?

My sense is, if the RBI will have its way, yes.

Note in this context, Deputy Governor Patel’s response to an analyst:

“So I do not think we are at a stage when real policy rates in a forward-looking manner are decisively positive or even neutral. The importance of the real policy rate is in some ways an indicative variable to show how accommodative or how strong monetary policy is vis-à-vis objectives related to inflation and so on. So, it is a concept that we need to think about a bit more carefully rather than in a static backward looking sense and more as a forward dynamic concept.”

But much will depend on the views of the new Government in June this year, and the outcome of the RBI’s discussions with the new Government.

Stability of monetary policy

A critical issue touched on in the post-statement conference call with analysts was the stability of monetary policy. I believe this is critical to the credibility of the RBI.

On this issue, Rajan gave the example of what the RBI could do if RBI finds that before January 2015 inflation falls below the target level of 8%. 

“To the extent that we find a substantial amount of room builds up before the interim target is reached, the question would then be “Should we cut tremendously now?” but then run the risk of not reaching the final target. And the general intent I think would be smoother process; however, to the extent that we have substantial room that builds up, that would prevent any further hikes in the interest rate and that would be useful.”

Both Rajan and Patel pointed out that the RBI is unlikely to react to what they see as transient increases and decreases in CPI.

Much of a central bank’s success in controlling inflation comes from the confidence of economic agents – the public - in the bank’s competence, transparency, and steadfastness for this task.

Transmission of Monetary Policy to lending rates is a problem

RBI’s operating tool of monetary policy is the repo rate and the operating target the call money rate (weight average rate). (The call money rate is the rate at which banks and primary dealers lend to each other on an overnight basis.) The objective of the RBI is ultimately to influence the deposit rate and lending rate of banks.  For example, when RBI raises the repo rate it wants banks to increase lending rate, thereby reducing borrowing, investments and aggregate demand, leading to a downward pressure on inflation.

Banks borrowing through the RBI window (through repos) forms a small proportion of its total funding needs.  Under normal circumstances, banks can borrow through repos up to 1% of its net demand and time liabilities (i.e. 1% of current accounts, savings bank accounts and term deposits). When banks fund their operations overwhelmingly through the public (retail or commercial), how could a rise in the repo rate increase banks’ lending rate? This explains why the link between RBI’s changes in interest rates and bank lending rates has been weak. The Urjit Patel report recognizes this problem (page 51 of report).

This issue of monetary transmission came up in the Rajan’s meeting with analysts.

Increases in the repo rate by RBI do increase we are told market interest rates, i.e. the call money rate, and yield curve of bonds – government and corporate. So the rise in the repo rate increases government borrowing costs, but does not necessarily increase bank lending rates.  Note the formal commercial sector depends predominantly on bank funds for borrowing and not on the corporate bond market. At the same time, the informal commercial sector, which is large, plays by its own set of rules.

In this context, Rajan in his conference call with the analysts said “I would not say that we have been totally irrelevant in the bank lending…. So I would not completely dismiss our having traction on the credit side, but as Deepak Mohanty said, the traction right now is coming through market interest rates”.

But this traction is limited. Banks get just 10% of its funding from the wholesale markets (reference page 49 of Urjit Patel Committee report).

So what is the solution? This is one of the recommendations of the Urjit Patel Committee:

“Unless the cost of banks’ liabilities moves in line with the policy rates as do interest rates in money market and debt market segments, it will be difficult to persuade banks to price their loans in response to policy rate changes. Hence, it is necessary to develop a culture of establishing external benchmarks for setting interest rates based on which financial products can be priced. Ideally, these benchmarks should emerge from market practices. However, the Committee is of the view that the Reserve Bank could explore whether it can play a more active supportive role in its emergence.”

I believe we need to be very cautious in following through with this recommendation. Today we have fairly solid and well managed banks, and arguably some world class banks. They follow good practices and take into consideration the key factors in pricing deposits and loans. RBI should not, in my view, even with the best of intentions – and we have seen the huge price we have paid through well-meaning regulation in India – end up unwittingly micro managing the pricing of deposits and loans. What RBI needs to do is follow through with all other measures to improve the transmission mechanism of monetary policy, such as reduction in or removing altogether mandated SLR requirements (the full list of recommendations is there in the Urjit Patel report).

Lags in transmission of Monetary Policy to the economy

Rajan referring to the no change in the repo rate at 8% indicates that the past increases in the repo rate need to work their way through the economy. So how long does this take? The Urjit Patel Committee report (page 44) states that “monetary policy in India impacts output with a lag of about 2-3 quarters and WPI headline inflation with a lag of about 3-4 quarters and the impact persists for 8-12 quarters”.

Money supply growth and interest rates

Consistent with the growth of the economy and inflation, money supply needs to increase. Today, the RBI’s operating tool is the interest rate (the repo rate) in achieving an inflation target (and GDP growth). Controlling money supply is not the route being taken to influence these macro variables.

But there needs to be a consistency between money supply growth and the inflation target, and there needs to be a consistency between the interest rate target and money supply growth. Rajan was questioned on this issue in the meetings. This is what Rajan had to say:

“Money supply target will be determined by what we expect credit growth and inflation to be consistent with the growth of the economy as well as the inflation we have in mind. And we will adjust our balance sheet to keep that in mind.”

Note the Monetary Policy Statement gives no guidance on money supply growth target in FY15.

Has the RBI started inflation targeting?

No.  This is a matter that will be taken up with the government. Rajan had this to say in his post-statement conference call with the press: “Whether we move to a specific target when we move, all that remains to be discussed.” Note, Rajan has publicly stated his preference (as reported in the press) for inflation targeting.

The Urjit Patel Committee (page 11) had recommended that inflation should be the nominal anchor for the monetary policy framework. The committee goes on to say that: “This nominal anchor should be set by the RBI as its predominant objective of monetary policy in its policy statements”.