2016-17
Last year at
the June statement, the RBI forecast the economy to grow at 7.6% in 2016-17,
and inflation was projected to be at about 5% by the end of the financial year with
an upside bias. Governor Rajan chose then to keep the key policy rate, the repo
rate, unchanged at 6.5%. Inflation then was about 5.5%.
The stat quo
continued at the next monetary policy statement. Then at the October statement,
the Monetary Policy Committee (India had then moved to a Committee approach from
the focus on the RBI Governor) resolved to reduce the repo rate to 6.25%
although there was basically no change in the RBI’s outlook on growth and
inflation. Perhaps, the RBI grew increasingly confident of achieving the target
rate of 5% CPI inflation by March 2017. And perhaps the RBI was influenced by
some slowdown in inflation from 5.5% to 5% in the intervening months.
At the next
statement in December, the MPC decided to make no change in the repo
rate. The statement acknowledged for the first time that growth in the economy
had been slower than expected, which prompted a revision in the growth target
for 2016-17 to 7.1% from 7.6%. Demonetisation of Rs 500 and Rs 1000 rupee notes,
which came into effect just about month earlier, was seen as having purely transitory
effects. In the intervening months – September
and October – inflation fell further to about 4%. RBI, however, retained its
inflation outlook at 5%, with the upward bias less pronounced.
In February,
at the final statement for 2016-17, there
was a change in stance although there was no change in the repo rate. The MPC chose to change the stance from accommodative to neutral, as the RBI apparently
was looking forward to 2017-18 and the medium term target of 4% inflation with
a band of +/- 2%.
Meanwhile,
the government’s CSO confirmed the slowing in the economy for 2016-17 to 7%,
down from its projection of 7.8%. Inflation continued to trend down – now to
3.5% in December, below 4% for the second consecutive month.
What about
RBI’s outlook on output and prices. RBI acknowledged for the first time that
inflation numbers were coming in weaker than expected and that for 2016-17 inflation
would come in below its target of 5%. The RBI did not put forward a path for
inflation in 2017-18. RBI further toned down its growth expectation to 6.9% for
2016-17. Growth was, however, expected to recover ‘sharply’ to 7.4% in 2017-18.
In this environment, it is indeed
baffling to me how the MPC could have chosen to change the stance of monetary policy
from accommodative to neutral. Neutral suggests that the repo rate could go up. (The
accommodative monetary policy was jump-started by Governor Rajan in an
unscheduled statement in early January 2015 outside the policy review cycle,
after five to six months of easing of inflationary pressures.)
In the first
nine months of the financial year inflation had come down from 5.5% to 3.5% -
even below RBI’s medium term target of 4%. The real interest rate for one-year
treasury bills had gone up from about 1.5% to 3%. The real rate is closely
monitored by the RBI, and has served as a bench mark for the RBI to decide the
pace of monetary easing. The RBI’s target for the real rate has varied but
recent statements suggested a desired level of about 1.5%. A real rate of 3% suggested that the RBI’s key policy rate, the repo
rate, was too high.
2017-18
At the first
statement for the new financial year, the MPC chose to keep the policy rate
unchanged. The statement noted CSO’s downward revision in the growth for
2016-17 to 6.7% from 7%. RBI now projected an inflation path of 4.5% in the
first half and 5% in the second half of the year, with the sense that
“underlying inflationary pressures persist”. Meanwhile, in the intervening
period since the last statement, inflation continued to be about 3.5%!
And then we
come to the statement last month. CSO further downgraded growth in 2016-17 to
6.6% - a full percentage lower than RBI’s projection of 7.6% in June of 2016.
There was a recognition that growth had decelerated in manufacturing and
services in Q1 and Q2 of 2016-17 – even before demonetisation. Meanwhile, the
new numbers on inflation in March and April showed further fall, with the
number for April below 3%.
RBI now
revised its inflation path significantly downward – 2 to 3.5% in the first half
and 3.5 to 4.5% in the second half of 2017-18.
Despite a
fall in inflation from 6% to 3% over the last one year (at the time of the
policy), a significant downward revision in the inflation path for 2017-18, and
the real rate on one year treasury bill in excess of 3%, the MPC chose to keep
the repo rate unchanged at 6.25% and monetary policy in neutral mode! For the
first time there was one dissenting voice at the MPC – Prof Dholakia voted for
a 0.5% reduction in the repo rate.
To my mind, the MPC has been well
behind the curve in reducing the repo rate. It should have kept the monetary
policy stance accommodative at the February statement, and reduced the repo
rate by 0.5% to 5.75%.
The change in the monetary
stance to neutral from accommodative has added volatility to interest rates,
and has probably been the main reason why government long bond rates rose by
about 30 basis points between January and May this year, making government
financing of its debt more expensive. Please see my monthly market maps. This in turn was not healthy for corporate debt - when
corporate investments are weak, and the economy is slowing.
Some other
observations on monetary policy
Money is the
fuel that runs the economy. The rate at which economic entities rent it is the
rate of interest on money. Monetary policy is to my mind about money supply, money flows
through banks, and other markets, as well as the rate of interest.
The supply
of money needs to have a close bearing with the rate of growth of the economy
and inflation - a standard lesson in
economics. In recent years central banks, such as the RBI, have placed all
their emphasis on using interest rates to control inflation while supporting
the growth of the economy. Hence the focus on using the repo rate – the rate at
which banks borrow from the RBI – as the principle tool in monetary policy.
This is standard policy in normal
times. But should this be the policy when the economy is in stress or in an
extreme position - either overheated or significantly weak?
It is
important for the Committee and RBI to make known the various linkages between
money supply – its various components – and prices and output in the economy. The
RBI’s monetary policy statements and related documents have little to say on
this subject. This is a policy lacuna.
Should not money supply and its
components also have an important role to play in monetary policy when there is
a shock to the financial system? Demonetisation of Rs
500 and Rs 1000 notes on November 8 last year was a shock – albeit for the
betterment of the economy in the long run - to the financial system. In no
large country had such a measure been executed. Overnight about 85% of India’s
money in circulation had to be surrendered, and replaced fully or partly in
quick time. As the
months progressed, it became clear that demonetisation could have sizable,
transactional, income and wealth costs on the economy – both transitory and some
sustained.
Over the
last one year, money supply grew by just 7% - well short of the
nominal growth of the economy - while during the same period a year ago it grew
by about 10%. Reserve money or high powered money actually shrank by 7%, while
the same period a year earlier it grew by 14%. The fortnightly statistics churned out by
the RBI have been showing such a picture over the last one year.
Then let’s
take a look at the picture on bank credit.
Interest
rate changes by the RBI work both as a signalling mechanism to the capital
markets, as well as directly by influencing banks to change the rate at which
interest is charged on loans and paid on deposits. Trends in deposits and
credit also could give advance notice to the RBI about what is happening in the
economy, especially in a country like India where so far as the formal economy
is concerned the credit market dominates the capital market.
Hence a close watch on trends in
deposits and credit should be part and parcel of RBI’s monetary policy
statement. Yet this has hardly any coverage at all.
The annual
growth in credit in India last crossed the 20% mark in 2010-11. Since then it has
trended down. In 2016-17 it was an anaemic 11%. RBI collects data on a
fortnightly basis on bank credit. In Q1 and Q2 of the last financial year,
2016-17, bank credit on a year-on-year basis grew consistently at or below 10%,
showed signs of weakening further in the fortnights going into demonetisation,
and then post-demonetisation fell sharply to the 4% level and currently stands
at 6% as per the last reporting fortnight in June. This is an extremely low number.
Then there
is the matter of the humongous bad debt burden on the public sector banks.
Non-performing loans ratio is in the region of 11%, a number that has only
increased over time.
It is worth
noting during the Great Financial Crash of 2008 the Federal Reserve took full
cognizance of its secondary effects on growth and inflation. The Federal
Reserve sharply moved interest rates lower, and given the severity of the
crisis moved from its normal world of positive real interest rates to a world of
negative interest rates.
I am not
suggesting that the RBI should move to negative real interest rates. But given
the stress (some may call it a crisis) in the financial system through bad
loans and historically low levels of credit flows and shock through demonetisation,
the MPC and RBI needed to focus not just on standard macroeconomic factors underlying
output and prices, but also on the money flows in the financial system. This
would give a clearer perspective on where the hold the key policy rate, the
repo rate. It would also give a better sense on where the real interest rate
should be – the current level of 1.5%-2% or arguably lower.
