Context: Former RBI Governor has cautioned RBI to preserve its inflation credibility and not to by-pass the monetary policy committee (MPC) framework.
- Following the global financial crisis of 2007-08, India, like many other countries, embarked on a stimulus package to reignite its economy.
- But by 2013 it had crossed or approached double-digit figures in inflation and the national fiscal deficit, in addition to looming bad loans.
- In summer 2013, when the Federal Reserve indicated a possible reversal of its ultra-accommodative policy, macroeconomic parameters for India were so weak that it got caught up in the “taper tantrum” and experienced external sector fragility.
- While fiscal excesses and financial sector stress remain issues today, India managed to improve significantly on at least one dimension — namely, inflation — which has also stabilised the external sector.
How did it manage to achieve the progress ?
- From 2013 , the institution initiated an effort to build credibility with domestic savers and international investors on maintaining inflation at prudent levels.
- Three years after the RBI Act was amended to put in place a flexible inflation targeting framework.
- A Monetary Policy Committee (MPC), comprising of RBI representatives and external members appointed by the Government of India, was enjoined with the legal mandate of managing the policy (repo) rate (the rate at which RBI lends money to banks)
Performance of MPC:
- By objective measures, the MPC framework until recently worked rather well.
- Given transparency and democratic accountability to the process of interest-rate setting;
- Brought inflation closer to the target;
- Contributed to tempering household inflation expectations; and,
- Kept borrowing costs in the economy at reasonable levels in spite of distortions
- Indeed, rating agencies and multilateral institutions repeatedly mention the MPC and the inflation targeting framework as a landmark structural reform towards sound macroeconomic management.
- Yet, since last year, somewhat inexplicably, a series of monetary actions by the RBI have
- left the MPC’s decision on the policy rate partly redundant,
- diluted the accountable process of monetary decision-making, and
- put at stake the sanctity of the framework.
How has this happened ?
- With a stated intention to improve the transmission of monetary policy to households and corporations, the RBI has pumped unprecedented levels of money (close to Rs 7 trillion) into the banking system.
- It has done so mostly by purchasing government bonds but partly also by purchasing dollars.
- Given impaired financial sector balance-sheets, transmission to economic growth has been at best muted; liquidity is no silver bullet to durably address financial sector stress.
- With its declared aim not being met satisfactorily, the RBI has doubled down on liquidity supply, with the same outcome.
- An important casualty of this has been the MPC framework.
- At times, even when the MPC has kept the policy rate unchanged, the RBI has injected yet more liquidity to move medium-term interest rates down.
- The two actions have been noted to be in direct contradiction of each other.
- Further, given the enormous liquidity glut, every night banks park liquidity with the RBI at a (reverse repo) rate lower than the policy rate and which is not set by the MPC; nevertheless, this rate used to be changed only as part of the MPC Resolution.
- Lately, the RBI has moved this rate progressively lower than the policy rate; recently, it has done so outside of the MPC meeting cycle and not as part of the MPC Resolution.
- The net effect is that market interest rates are being increasingly controlled by the RBI rather than the MPC.
Impact on Future Course:
- These developments have the potential to pose risks for India’s macroeconomic stability going forward:
- The implicit monetisation of fiscal expenditures through government bond purchases by the RBI in the secondary market has postponed the recognition of the untenable fiscal reality.
- The delay has meant the government has had limited policy space since the onset of COVID 19.
- Supply-chain disruptions due to measures taken to contain the pandemic raise the possibility of cost-push inflationary pressures, especially given the excessively easy fiscal and monetary conditions.
- This can abruptly raise economy-wide borrowing rates, inflict losses on banks, and imperil financial stability.
- If the gains in inflation credibility built by the MPC framework are dissipated by ineffective policies and operations, both household and investor expectations for inflation in India could unhinge.
- It is disturbing that while referring to desirable levels of inflation, analysts appear to have already stopped referring to MPC’s mandated target inflation rate of 4 per cent and the focus has instead shifted to the upper tolerance limit of 6 per cent.
- Worse, it could instigate turmoil in the external sector. Excessively low bank deposit rates may induce some non-resident deposits to exit the country.
- It is unclear how the MPC can be expected to satisfy its legal mandate if what it seeks to achieve via setting the policy rate is in conflict with, or compromised by, the RBI’s liquidity management.
- In a highly unpredictable time such as this, the RBI should preserve its inflation credibility.
- This requires making the institution of MPC more enduring, not bypassing it.
- Decisions on monetary policy actions based on voting by committee members,
- provision of inflation and growth forecasts in the resolution statement, and
- coordination of rate-setting and liquidity management, need to be adhered to.
- Even in desperate times, we need to follow due processes and justify with substance the extraordinary actions so that commitment is provided as to how these actions will be unwound when necessary.
Monetary Policy Committee:
- It is responsible for fixing the benchmark interest rate in India.
- The committee comprises six members - three officials of the Reserve Bank of India and three external members nominated by the Government of India, with RBI Governor being the Ex officio chairman.
- Decisions are taken by majority with the Governor having the casting vote in case of a tie.
- The current mandate of the committee is to maintain 4% annual inflation until 31 March 2021 with an upper tolerance of 6% and a lower tolerance of 2%.
- The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.
- They need to observe a "silent period" seven days before and after the rate decision for "utmost confidentiality"
- The Reserve Bank of India Act, 1934 was amended by Finance Act (India), 2016 to constitute MPC which will bring more transparency and accountability in fixing India's Monetary Policy.
- The committee is answerable to the Government of India if the inflation exceeds the range prescribed for three consecutive months.
- The Reserve Bank’s Monetary Policy Department (MPD) assists the MPC in formulating the monetary policy.
- Views of key stakeholders in the economy, and analytical work of the Reserve Bank contribute to the process for arriving at the decision on the policy repo rate.
Image Source: MapsofIndia