Monetary Policy: A hesitant pause

Yes, it’s a pause, but with some trepidation, seemingly. The Monetary Policy Committee of the RBI in its first meeting of FY 2023-24, which concluded on April 6, 2023 voted unanimously to keep the policy repo rate unchanged at 6.5 per cent. No change in the current stance of the policy aimed at ‘withdrawal of accommodation’ was also announced, albeit with one dissent vote. Both the equity and government securities market responded positively to the monetary policy announcements.

A majority of the market analysts expected the MPC to raise the policy rate by another 25 basis points to 6.75 points before hitting the pause button. Seen against this backdrop, the policy action carried a mild surprise element. But more importantly, one finds a few unusual features and senses some trepidation in the policy statements and narratives.

A ‘pause’ for only one policy meeting?

In his live address covering the policy statement, RBI Governor Das remarked “Let me emphasise that the decision to pause on the repo rate is for this meeting only.” The full meaning and significance of this sentence is not immediately clear. If it was intended to convey a message that the pause will not constrain the MPC, in any way, to increase the repo rate in the next meetings, a question will arise why such an explicit caveat was necessary in the first place? Each MPC decision on monetary policy is taken independently following its mandate and in the light of the latest available facts and information. Why, then, state the obvious?

Excessive reliance on inflation projection

The ’pause’ decision seems to have been influenced by some of the points that were highlighted by a member of the MPC who voted against the rate hike in the last (February, 2023) meeting:

• With the average CPI inflation forecast for 2023-24 of 5.3 per cent (now reduced to 5.2 per cent), the real interest rate is already positive (in excess of 1 per cent) and is likely to become more so, if inflation falls further vis-à-vis the average.  A real repo rate of around unity suits the current stage of the cycle. It balances the conflicting requirements of inflation and growth, savers and borrowers well. A sharp rise in the real policy rate, substantially above unity, would trigger a shift to a lower trend of private investment and growth, and the sacrifice ratio of disinflation could be very high.

• On March 22, 2023, the Federal Reserve announced another hike in the policy rate by 25 basis points to raise it to 4.50 per cent. As seen in the past, when the Fed tightens, interest rates tend to rise more in EM countries, accompanied by currency depreciation. The Fed’s action is due to large excess demand, tight labour markets and an unprecedented deviation from the inflation target in the US. India does not have these conditions and has the space not to follow the Fed, particularly in the light of the significant improvement in the current account as also in the overall BoP position since the beginning of 2023. The fall in forex reserves in the last quarter of 2022 has now been reversed.

• The policy rate in the current tightening cycle has been raised cumulatively by 250 basis points within a relatively short period of about 10 months. Since monetary policy actions are known to impact the real economy – output and inflation – with a time lag, it would be apposite to pause and see how the things play out in the coming weeks and months. Excessive front-loading of rate hikes carries the risk of over-shooting that is best avoided.

However, the ‘pause’ decision seems to rest mainly on the significantly lower CPI inflation projection for Q1 of 2023-24 at 5.1 per cent and 5.2 per cent for the whole fiscal. Without going into the technicalities of the methodology of forecasts, it would be fair to say that the headline inflation may as well moderate in H1:2023-24. But it would still be well above the target of 4 per cent for an extended period, with occasional spikes, as was the case in January and February this year.   

Excessive front-loading of rate hikes carries the risk of over-shooting that is best avoided  

Another factor that has surely influenced the decision is the downside financial stability risk that may arise out of the contagion effect of the recent banking crisis in few advanced economies. In the assessment of the RBI, the banking sector turmoil in those countries has dented improvements in the global macroeconomic outlook that were witnessed earlier this year and have added to the prevailing uncertainties.

Developmental initiatives

The decision to permit residents to enter into rupee-settled non deliverable derivative contracts (NDDCs) with banks which have IBUs in IIFC is a welcome step. This will give an additional tool in the hands of Indian corporates to flexibly hedge their foreign exchange exposures in a cost-effective manner. That said, it is not clear why banks without IBUs in IIFC have been left out of the game, although they may be equally capable of offering NDDCs to their customers. Regulations, as a matter of principle, shouldn’t result in more business opportunities to one set of regulated entities in preference to others.       

The move to expand the scope of UPI by enabling transfer to / from pre-approved credit lines (PACL) at banks, in addition to deposit accounts, will have far-reaching consequences. A few banks have been making demands in this regard for some time.  Quite clearly, it is the first step to use the UPI network for facilitating payments financed by credit from banks. In recent years, PACL has emerged as a major retail loan product for banks and NBFCs alike with a very impressive growth trajectory so far. Now that PACL will be able to ride on UPI, it has the potential to emerge as an alternative to credit cards, provided banks put in place a robust limit control mechanism aided by appropriate technology.

For inflation to align progressively with the target of 4 per cent in a durable manner, a better long-term strategy is needed

Economist John H. Cochrane in a recent interview commented ‘Economics is really not about short-term forecasting or peering at the latest numbers. Economists are better at conducting “if-then” analysis and discerning longer-lasting forces.’ The fact that  headline inflation in India has been higher than 4 per cent for more than three years and above 6 per cent for the most part of 2022 and in the first two months of 2023 indicates that that there are larger forces at work than are captured in monthly/quarterly inflation and growth numbers. For inflation to align progressively with the target of 4 per cent in a durable manner, a better long-term strategy is needed.

(The writer is a former central banker and a consultant to the IMF)