Monetary Policy: A look back over the last year.

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.