Friday 7 June 2019
India Market Map: May 2019
Foreign Exchange
Wednesday 5 June 2019
A review of monetary policy: there is a serious need to correct flawed policy execution
In February (fifth bi-monthly for 2018-19)and April (first
bi-monthly for 2019-20), the Monetary Policy Committee (MPC) reduced the repo
rate by 25 basis points each to bring the rate down to the current 6%.
I
agree with the moves, and recommend that the MPC should reduce the rate further
by 50 basis points tomorrow at the second bi-monthly statement for 2019-20. I
also feel that the stance of monetary policy should be changed from neutral to
accommodative.
Over the last three years, I have consistently held the
view that monetary policy has been too tight. In July 2017 in my review of
monetary policy I had expressed the view that monetary policy was too tight, that
the repo rate should be reduced by 50 basis points from the then prevailing
rate of 6.25% to 5.75%, and that the baffling change in monetary stance from
accommodative to neutral in February that year (2017) was the main reason for
the volatility in bond rates.
In July last year, I was against the decision of the MPC
to raise the repo rate – a clear sign of tightening – in June. I had then
written the following:
“There is no doubt that
inflation has been trending up. But whether this a case of a return to normalcy
as a result of the slowdown in the economy in the last two years or something
structural is not clear at all. One thing that appears apparent is that the
sharp fall in inflation coincided with the post-demonetisation phase, just as
the recent rise in inflation has coincided with the projected return to
normalcy of the economy.”
Again in November last year, I once again opposed the MPC’s decision to raise the repo rate in
October.
RBI’s forecasts of inflation
A key input in the MPC’s decision
is the RBI’s forecast of inflation. The table below tracks - with each
bi-monthly statement - the RBI’s forecast of inflation over the last three
financial years.
The RBI has consistently forecasted inflation
far higher than the rate that has materialised over the last three years! It takes time for a change in the key policy
rate to work its way through the economy – anything from four to six quarters. So
I am using the average of the first three estimates as a guide to see whether
the RBI is off or on target in its forecast of inflation - as this is what is
relevant to the MPC making a correct decision. In 2016-17, the average estimate
was 1% above the actual; in 2017-18, the estimate was on target but in the
first half of the year it was higher by 1.25%; and in the last financial year, 2018-19,
the estimate versus actual was off target by a stupendous 2%! This is one clear reason why monetary policy has
been too tight, i.e. the repo rate was being kept far higher than is what is
warranted by inflation.
Can the RBI get its
inflation forecasting model to work better? It is critical to do so. An alternative thought for consideration is
that since forecasting inflation in India is virtually impossible – food and energy
are large components and very volatile - it is perhaps better to look at
historical inflation numbers – the past numbers. At least these are certain
and better than basing decisions on inaccurate numbers of the future, which
give a false sense of certainty.
RBI’s view of the real interest rate
Both the current governor’s
predecessors – Rajan and Patel – and top RBI staff stated that the RBI kept a
close watch on the real rate, and the goal was to keep the rate at about 1.5%.
At the post-statement conference call with analysts in February this year, Deputy
Governor Viral Acharya seemed to have watered down this objective when he said “it
is not something whose specific level we target in particular”.
I feel that the RBI and MPC should have a real
interest rate goal. As in many concepts in economics, it is the “real”
rather than the “nominal” which plays a key role in the public making decisions
and responding to policy. A classic example is GDP – the public, from individuals
to businesses to governments, track the growth in real GDP, the commonly
visible growth rate of the economy in the media and official statistics. The
nominal GDP growth numbers are subsidiary. Another example is the distinction between
the nominal exchange rate and the real exchange rate.
It is the real interest rate – the nominal rate
less inflation – that influences, consciously or unconsciously, the decisions
of the public to towards risk, consumption and investment. Hence when an economy is growing too fast or
inflation is too high, it is important for the central bank to move the real
rate to a higher level. Or if the economy is growing too slowly or there is disinflation
or there is a crisis in the financial system debilitating to the economy, it is
just as important for the central bank to move the real rate lower than normal.
With inflation around 3%, and one-year treasury
bill yielding about 6.25%, the real interest rate is well above 3%. This is
just too high, and despite two reductions in the repo rate, monetary policy is
too tight. We may get
fooled into thinking that the MPC has loosened policy but it has not! Look where the growth of the economy is
trending: growth on an annual basis last year was 6.8% after 8% two years ago;
on a quarterly basis growth in Q4 of last year (2018-19) was less than 6%, the
worst quarter in the last twenty.
So as I recommended
earlier, the MPC should reduce the repo rate by another 50 basis points in one
step to 5.5% - this would still keep the real rate well above 2% even if the
one-year treasury bill rate fell in response to 5.75%.
India’s banking crisis
I have held the view consistently that the bad loan crisis in India’s banking system dominated by
the public sector is “really similar to the Great Financial Crisis that
enveloped the developed world in 2008”. We are still not out of the woods on
this one. The inability of the government to fully recapitalise the public
sector banks, the consistent shrinkage in bank credit in the last three years –
a fact that should have given clear signals to the RBI and MPC on inflation and
growth, the spread of the crisis in a lessor but significant way to the NBFC
sector in the last year, suggests a systemic long drawn crisis.
My view is that the MPC
should have recognized this as an explicit factor in framing policy – going beyond
its regular template of macroeconomic variables- and responded to it by reducing
the real rate even lower than its past target of 1.5% to about 1%, and thereby
loosened monetary policy earlier and faster.
Growth of credit and deposits in the banking
system
I have been monitoring on
a regular basis trends in the flow of credit and deposits over the last several
years – please see my blogs under the tab banking industry. Money – credit, deposits,
money supply and reserve money - is the fuel that runs the economy, having an
important influence on both the price and output, although my sense is that we do
not know enough of its influence especially in such a quickly evolving India. Trends
in the flow of money give valuable early signals to the RBI on the conduct of
monetary policy. Hence this should be a key input to the deliberations of the
MPC. Inexplicably, this is missing.
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