Behind the monetary policy surprise

Contrary to widespread expectations of an increase of 25 basis points (by 50 bps by some), the Monetary Policy Committee (MPC) has maintained the status quo on the policy rate. Despite turbulent market conditions and liquidity easing measures taken in the days leading to the policy, it changed the policy stance from “neutral” to “calibrated tightening”. This implies that in the current rate cycle there is no scope for a rate cut but there would be either increases, albeit in small doses of 25bps, or pause. Again, many had thought the RBI would use the latest shadow banking crisis to go beyond its singular focus on inflation to highlight the financial stability concerns as the systemic risk manager of the economy; this hope was belied when Governor Patel re-emphasised and reinforced the legislative mandate of managing inflation. It was also expected that given the sharp and sustained depreciation of the Rupee and the associated macro risks of higher imports/CAD, imported inflation, fiscal slippage, growth deceleration and capital outflows from the equity and bond markets, RBI would reiterate its commitment to maintain the external value of Rupee. In the post policy press conference, the market, however, got the impression (unintended though it may be) of RBI’s “standoff” approach.

Not really unexpected

With the pronounced preference of the internal members of the MPC in favour of inflation targeting vis-à-vis the earlier multiple indicator approach and strong anti-inflationary bias of one of the external members, Chetan Ghate (of the other two external members, Pami Dua is possibly the “neutralist” and Ravindra Dholakia the acknowledged “dove”), RBI has now fully internalised the inflation targeting framework. In the previous policies, the urge to move to a tightening mode was becoming clearer. The elevated risks in meeting the inflation target of 4 per cent on a sustained basis arising from escalating oil prices, increase in the  minimum support price (MSP) of agricultural products, possibility of fiscal slippage for the Central and State Governments taken together, sharp rise in input costs with potential pass through to retail prices, closing up of output gap, rising inflationary expectations evident from RBI’s household survey and impact of HRA hikes by the States were taken as the triggers for shift in the stance. Even then, the rationale for choosing exactly this occasion, when financial market conditions are highly volatile and the near-term inflation projections have been lowered, is not clear.

That the repo rate was not raised is explained by the following: (i) recent prints and near term projections for headline inflation being lower than the earlier estimates, mainly due to deceleration in food prices, (ii) providing allowance for the last two hikes in the space in two months to play out their impact, (iii) interest rate instrument is to be used only for inflation management and the exchange rate has to be handled separately  through intervention and other short/long term measures and (iv) implicit acknowledgment that in any case the interest rate channel may not be effective for currency defense , more so as the debt capital flows are highly regulated in India.

The other possible reasons for the pause could be: (i) muted growth concerns arising from tighter global and local financial market conditions and rising oil prices and trade tensions, (ii) highly elevated rates prevailing in the money markets and corporate debt segments, partly because of the domino effect on the NBFC sector following the IL&FS collapse and (iii) real interest now being more than 2 per cent.  The possible reason for not reclaiming explicitly its financial stability mandate is that it is better to take on the responsibility of achieving a single and significant objective of price stability through the time-tested instrument of interest rate and deliver rather than being explicitly entangled in the complex and complicated task of systemic surveillance.

What is surprising

Specifically, on Rupee volatility, in the post policy press conference, Deputy Governor Viral Acharya repeated RBI’s long-standing stance of not targeting any rate or band but managing excessive volatility. What was surprising, however, was the emphasis that the exchange rate is to be determined by demand-supply dynamics in the forex markets and rate adjustments are necessary to mitigate terms of trade shocks, thereby neutralising to some extent the interventions RBI has been doing in the forex market to arrest sharp falls in Rupee. The actual impact of interventions, even when done in small quantum, often becomes more effective when they are supported by tactical open mouth operations aimed at quelling the self-fulfilling tendencies of the markets.

Of course, Governor Patel did try to convey that RBI has the capacity to counter any serious speculative attacks on Rupee with its USD 400-plus billion reserves. Another way of looking at this is that the RBI is not unduly perturbed by recent falls in the value of Rupee as is the case with many other EME currencies due to global factors and if it does not auto correct RBI has the wherewithal to handle the extreme situations. Surprisingly the market did not get the message as was possibly intended to be with Rupee breaching the 74 mark post the policy/conference. If the sharply sliding Rupee trajectory is not reversed the market may be in for more strategic interventions and sharper communications from RBI. 

 (The author is a former Deputy Governor, Reserve Bank of India. Views are personal)