'Policy stance has entered the neutral zone'

The decision of the MPC of RBI to keep the policy rate unchanged at six per cent in its bi-monthly meeting held on October 3-4, 2017 was perfectly in line with the market expectation. There was a minority opinion in favour of a 25 basis point rate cut. The announcement of an inflation palliative in the form of excise duty cut of ₹2/litre on petrol and diesel the previous evening kindled some last-minute hope of a rate cut. But those were belied as the curtain rose at 2:30 PM on October 4. 

The MPC lowered the growth projection for the current fiscal to 6.7% from the August 2017 print of 7.3%, with risks on both upside and downside evenly balanced in its view. Growth rates for Q3 and Q4 are expected to pick up after the dip observed in the first two quarters. However, it hedged its bet on whether the current output gap and slack is a blip or not by saying that it needs “more data to better ascertain the transient versus sustained headwinds in the recent growth prints”.  A sensible approach, by all means.

There are concerns in certain quarters that the market has entered the ‘bubble territory’. Regardless of whether everyone would like to characterise it in such an eye-catching way, past experience shows that a combination of an overvalued rupee and equity enhances threats to stability of financial markets in this country.

On inflation, the MPC averred that the softness in prices, including those of food items observed in Q1 of this fiscal, is reversing in a broad-based sense. Latest urban household inflation expectation is a shade lower, but the proportion of respondents who expect higher prices in the months ahead has risen.  It expects the CPI inflation to rise from 3.4% in August 2017 to 4.6% in Q4. The balance of risks appears to be uneven, with more chances of an overshooting.

On the whole, MPC's decision to maintain status quo is a reflection of its mandate to steer the inflation trajectory closer to 4% by taking pre-emptive action or no-action, as in the present. The easing cycle that began in January, 2015 has most possibly come to an end with the cumulative lowering of the repo rate by 200 basis points. The policy stance has entered the neutral zone. 

Among the other measures that have been announced, one of the most important ones is the in-principle decision for adoption of external benchmarks by banks for pricing their loans and advances and, by extension, their liability products on the basis of appropriate external benchmarks.  This follows the international best practice. Apart from ensuring better monetary policy transmission, it will make possible adoption of objective transfer pricing system in banks that will harmonise the incentives of different business units. Reduction in SLR will enhance profitability of banks, apart from meeting certain regulatory objectives.

This policy statement does not contain any new idea or initiative on resolving the massive NPA of PSU banks. The MPC, however, has tacitly recognised that revitalisation of investment activity and recapitalisation of PSU banks are closely entwined issues.

A huge overhang of liquidity caused by demonetisation of last year and sluggish bank credit growth contribute, at least at the margin, to still higher equity valuation in India. There are concerns in certain quarters that the market has entered the ‘bubble territory’. Regardless of whether everyone would like to characterise it in such an eye-catching way, past experience shows that a combination of an overvalued rupee and equity enhances threats to stability of financial markets in this country.

The continued lacklustre export performance and the widening of the current account deficit to 2.4% of GDP in April – June, 2017 from 0.6% in the previous quarter and the current overvaluation of the rupee are not an isolated phenomenon. The rupee appreciated in real terms by about 7% during the last 12-15 months alone. RBI and government should agree on a gradual and orderly adjustment of US$/₹ rate to 66-68 range.  This will mean an overlay of accommodation on the neutral monetary policy stance and will help exporters.  

Shouldn't the MPC members form their individual views and opinions based on projections of growth and inflation and other relevant data analyses as prepared by RBI staff following robust methodologies vetted by MPC itself?

This meeting of MPC also marked the completion of the first year of the six-member panel. Like all similar policy-making assemblages, MPC also has been riding a learning-by-doing curve, which is presumably steep. But the learning outcome is very encouraging, if the compact and elegant prose in which the members have explained their views are anything to go by. Of special mention are the narratives penned by the two differing members of the previous meeting which had decided to cut the rate by 25 basis points.  While one of them was in favour of a steeper cut, the other was in favour of no change in the policy rate. The resultant diversity of opinions resembled a nice-looking normal distribution which, if continued, would be a welcome aspect of the functioning of MPC, going forward.

At the core of the difference of opinion among the two members were their fundamentally different approach and perception about the relative emphases on growth and inflation and the future path of inflation.  More importantly, they relied on two different sets of forecasts on the question of projected inflation. This brings us to an important question: shouldn't the MPC members form their individual views and opinions based on projections of growth and inflation and other relevant data analyses as prepared by RBI staff following robust methodologies vetted by MPC itself?  Also, it should address another quintessential issue: Monetary policy-making under inflation-targeting should largely be based on a set of broadly defined rules, and one is not talking about having something like a computer programme here.  Among other benefits, this will make the views and opinions of members more comparable, which will enhance MPC's credibility.       

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