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-Ã -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”.
