Time for a neutral stance on monetary policy

The Monetary Policy Committee, at the conclusion of its third bi-monthly meeting for 2022-23, unanimously decided to raise the policy repo rate by 50 basis points to 5.40 per cent. On the monetary policy stance, the MPC, however, implicitly decided to continue with the accommodative mode through the use of a somewhat rhetorical expression: ‘to remain focused on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth.’ This resolution was not unanimous, with one member dissenting.

The policy was broadly in line with the expectations of the market, although there was also a view on the back of increasing prospects of a recession in the US, implying a much less aggressive policy tightening by the Federal Reserve in the months to come, that the MPC may settle for a 35-40 bps rate increase this time.

Post the policy announcement, the overnight call rate traded higher by 40-50 bps vis-à-vis the previous day. The 10-year benchmark yield rose by about 13 bps to 7.25 per cent, implying a flattening of the G-Sec yield curve. The rupee remained more or less unchanged, while the equity market moved higher on no change in the GDP growth projection for 2022-23 at 7.2 per cent.

The MPC is guardedly optimistic on the growth prospects of the economy for 2022-23 as a whole, although there is going to be a good deal of quarter-to-quarter variation in growth rates, and some distortion thereof due to base effect. That said, the growth impulses in the economy seem to be broad-based and, hence, sustainable.

The findings of the RBI’s industrial outlook survey are corroborated by the latest survey conducted at IIM Ahmedabad, which indicates early signs of improvement in sales and profit expectations. The CPI inflation projection for 2022-23 has been retained at 6.7 per cent, with a declining quarter-to-quarter trajectory. It is expected to fall marginally below 6 per cent — the ceiling of the current target band — in Q4:2022-23 and further to 5 per cent in Q1: 2023-24.

Rupee under selling pressure

The selling pressure on the rupee in the forex market, accompanied by sharpened volatility in its exchange rate vis-a-vis the US dollar that was witnessed in the recent months has caught the attention of all and sundry, including politicians on both sides of the aisle.

The exchange rate briefly crossing the historical low of ₹80 per dollar in July became an emotive issue, causing even some of the cognoscenti to predict, with haste, that it is likely to drop to ₹90 sooner rather than later. Sustained forex market intervention by the RBI together with a few favourable external sector developments, including some easing trends in the global oil market, have stabilised the rupee, at least for the present.

As against the highest fall of 5.40 per cent recorded thus far in this fiscal, the rupee stood lower by about 4.35 per cent after the policy. This is not excessive by any reckoning, because the real exchange rate appreciation of the rupee vis-à-vis both narrow and wide baskets of currencies of India’s trading partners was around 4 per cent (Base: 2015-16) in May-June 2022 (the latest months for which REER data has been published by the RBI).

In the past, most of the episodes of intense selling pressure on the rupee occurred when it was overvalued in real terms, triggered by one or more external events. To be sure, the external triggers were many this time around, including the sharp reversal of extra loose monetary policies and the so-called quantitative easing that has been pursued by the Federal Reserve for several years.

By all indications, the RBI has spent only a relatively modest amount of its forex reserves in defence of the rupee: the foreign currency assets (FCA) of the RBI as on July 22, at $510.14 billion, was only $35.75 billion less compared to end-March 2022. Although the latter-mentioned number can vary from the actual amount of US dollars sold by the RBI in the cash and derivatives markets during this period, yet it gives some broad information in this regard.

Further, there has not been any major change in the net forward purchase position of the RBI during this period.

Coming back to the issue of the intense selling pressure that grips the rupee at infrequent intervals, three things are important from a risk containment point of view: One, the MPC should relentlessly pursue its inflation-targeting mandate, which will obviate the possibility of any large accumulation of real exchange rate appreciation of the rupee and their eventual correction through sharp downward adjustments in its nominal exchange rate. For all we know, such corrections in the nominal exchange rate usually have a tendency to overshoot.

Two, the RBI should continue to build forex reserves whenever there are opportunities to do so: in today’s milieu where the post-Cold War world order is under serious threat, India’s strategic interests will be well-served by an ever-increasing kitty of forex reserves. Unlike in the case of other countries with large forex reserves, India’s reserves are callable to a large extent, since the country’s current account is not in surplus.

Three, the country needs a much more organised and sophisticated framework and mechanism for external sector monitoring and surveillance than is the case now.

An alternative benchmark

In the Statement on Developmental and Regulatory Policies, accompanying the policy announcement, one finds the RBI’s plan to form a panel to examine the matter relating to the search for an Indian alternative benchmark (reference) rate — termed ARR globally. This issue has gained importance in recent years as a result of the cessation of the LIBOR benchmark, slated for completion in 2023.

In India, as in other countries with similar capital controls, a pure rupee benchmark interest rate like MIBOR will not serve the purpose of all market participants and users. This is especially true of those who want to hedge their forex assets/liabilities through swaps based on MIBOR. Hence, it will be necessary to follow the same approach as was the case with the erstwhile MIFOR swaps, that combined US dollar LIBOR and US dollar/rupee forward premium of the same tenor as reference rates for generating synthetic rupee term curves.

The US dollar LIBOR needs to be substituted by SOFR that is used for borrowing and lending.

A balanced policy

Overall, this a good and balanced policy. It seems that the MPC, through its policy rate decision in this meeting, wants to send a message that it does not want to be ‘behind the curve’. This will certainly boost the image of the MPC in the eyes of the financial market.

However, given the broadening of economic activity, impressive performance of the manufacturing and services sectors and improvement in their pricing power, uptick in capacity utilisation, large expansion in bank credit, etc., there is an urgent need for the RBI to forsake its current ambivalence and shift to a neutral stance of monetary policy. Doing so will further reduce inflation expectations, on the one hand, and further flatten the G-Sec yield curve, on the other.