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.