MPC does a tightrope walk

As widely expected, the MPC of RBI unanimously decided to keep the policy rate unchanged at 6.5 per cent on conclusion of its third bi-monthly meeting for FY 2023-24 on August 10. The stance of the policy was also kept unaltered, albeit with one member dissenting.

However, a section of the market expected a modest hike in Cash Reserve Ratio (CRR) in view of the increase in the liquidity of the banking system by about Rs. 3 lakh crore due to the return of Rs. 2000 currency notes. Hence, the incremental CRR measure announced by the RBI (more on this later in these columns) came as a kind of mild relief to them. A more hawkish tone on inflation containment in the policy statement was correctly anticipated by many.

Another pause by the MPC is no sign that the peak policy rate is here

The equity market retreated a bit after the policy. The government securities market didn’t react much. 

Inflation-Growth Dynamics

At the last bi-monthly meeting in June, 2023, the MPC projected CPI inflation at 5.1 per cent for 2023-24, with Q1 at 4.6 per cent, Q2 at 5.2 per cent, Q3 at 5.4 per cent and Q4 at 5.2 per cent. All those projections, excepting for Q4 have now been revised upwardly:   5.4 per cent for 2023-24, with Q2 at 6.2 per cent, Q3 at 5.7 per cent and Q4 at 5.2 per cent. CPI inflation for Q1:2024-25 has been projected at 5.2 per cent. The obvious upshot of the fresh projections is that achievement of the target of 4 per cent for the headline CPI will likely be a long and arduous affair even under the best of circumstances, i.e., when the risks are evenly balanced. The MPC is surely mindful of the fact that even if the actual CPI remains in the 5-6 per cent range for a long period, the credibility of its commitment to achieving the target of 4 per cent will suffer. Nevertheless, the MPC can derive some comfort from the fact that the core inflation (inflation sans food and fuel) has softened by more than 100 basis points from its recent peak in January 2023. But crude price will continue to be vulnerable to any renewed geopolitical tension.  

The MPC hasn’t made any change in the growth projections for 2023-24: real GDP is likely to grow at 6.5 per cent, with manufacturing and services sectors doing very well. 

Incremental CRR as a Liquidity Management Tool

The reasons adduced for the imposition of 10 per cent incremental CRR on the increase in net demand and time liabilities of scheduled banks between May 19 and July 28 of this year are not very convincing.  Also, it is not clear what precise purpose it is intended to serve, especially because of its implied temporary nature. This measure would impound from the banking system an estimated Rs. 75,000 crore or about 40 per cent of the current daily absorption of liquidity under LAF.   Use of CRR for inter-temporal liquidity adjustment is likely to send a wrong message, indicating some weakness of the LAF tools and OMO that have long been used by the RBI.  Is it the case, therefore, that a CRR enhancement at the margin has been announced to buffet the overall hawkish tone of the policy? Only time will tell.

Regulatory Policies

The extant regulatory framework for financial benchmarks related to forex, interest rates, money markets and government securities that was issued in June, 2019 applies only to the so-called ‘significant’ benchmarks. By implication, administration of other financial benchmarks, and there are quite a few important ones in this category like indices of government securities, forward forex market rates etc. are currently beyond the regulatory purview. This creates anomalies and regulatory arbitrage.

Use of CRR for inter-temporal liquidity adjustment is likely to send a wrong message, indicating some weakness of the LAF tools and OMO

Administration of financial benchmarks is a critical function and it is necessary that all the agencies pursuing this business are subjected to a uniform set of regulations so that there is a level playing field, on the one hand, and best-of-the-class governance standards entailing, among others, complete absence of any conflict of interest, on the other. One expects that these issues will be properly addressed in the revised directives to be issued by RBI. One also hopes that all the major financial market regulators viz. RBI, SEBI, IRDA and PFRDA will work jointly to pave the way for the use of uniform valuation benchmarks in respect of corporate bonds by all the regulated entities.  

The steps announced for enforcing greater transparency in interest rate reset of EMIs in loans bearing floating interest rates, though welcome but stop short of addressing a fundamental design flaw of most such loans: mismatch between the tenor of reset (usually three months) and the tenor of the interest rate (mostly overnight policy repo rate). Apart from giving rise to wrong incentives for the lenders and their borrowers, the interest rate risk associated with such a design becomes a bit complex the hedging of which poses few additional challenges.

Has the current tightening cycle already reached its peak at 6.5 per cent? The most optimistic opinion in this regard tells us that the MPC will begin to reduce the policy rate towards the end of June, 2024 – more or less at the same time when the Federal Reserve is also expected to do so. However, higher-than-expected CPI print for June, 2023 at 4.81 per cent, snapping a four-month declining trend, to be followed by 6.2 per cent expected in Q2:2023-24 keeps alive the possibility of another rate hike by 25 basis points later in FY 2023-24. The MPC will likely be ever more watchful of the second-round effects of high food prices and the consequent challenges to the anchoring of inflation expectations.

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