Unfolding the monetary policy statement

The RBI Governor has held his ground. If there was pressure, covert and overt, to cut rates and give a boost to growth, Mr. Raghuram Rajan has made it clear that he is not about to bow to demands that don’t fit into the RBI view of the economy.

So despite all the political noise in the run up to today’s second bi-monthly policy statement, the key interest rate (the policy repo rate) remains unchanged at 6.5% and the Cash Reserve Ratio (CRR) is unchanged at 4%. But these two bullets at the top of the policy announcement come along with a third that carries implications for the monetary policy framework.

This is the focus on liquidity management – from a situation of systemic liquidity deficit to one of close to neutrality. Simply put, this means that the RBI accommodation will now be less in terms of injection of liquidity to the banking system through the overnight repo window. This is a reiteration of the April policy under which liquidity management assumes importance as a part of monetary policy.

The upcoming implementation of the 7th Central Pay Commission awards adds to the adverse inflation dynamic. There is also the rise in inflation expectation of households and corporates. Stickiness in retail inflation (excluding food and fuel) is equally a matter of concern and raises the risks of higher inflation trajectory.

The Governor has not set any timeframe for this but the direction toward neutrality comes at a time the RBI has also raised concerns on FCNR-B (Foreign Currency Non Resident- B) deposits kept in Indian banks mostly by NRIs. This was a special RBI scheme launched in 2013 aimed at boosting reserves. About USD 25 billion came into the system as a result then.  As much as USD 20 billion of leveraged amount is likely not to be renewed, leading to an outflow which can cause dollar shortages in the economy and ultimately pressure on the currency. This is not a surprise to the market.  To mitigate such pressure in a non-disruptive manner, RBI has already taken forward market cover and has committed to supply dollars in case of volatility. This comes as a welcome assurance to the market.

But the question remains: With Consumer Price Index (CPI) inflation at 5% and the growth number coming it at 7.6%, and with predictions of a good monsoon, why has RBI not moved this time to lower rates? The answers lie in a range of signals that are a source of concern while everything looks fine on the surface.

Two key constraints limit the space to reduce rates, according to the RBI.

The first is inflation, which may be low now but carries the potential to move higher due to a seasonal increase in food prices. Furthermore, vegetable, fish, meat and pulses prices have remained at an elevated level. Also, services inflation remained at higher level due to house rents, water charges and taxi/ auto fares, the RBI has noted. Coupled with this, there is an uptrend in international commodity prices, especially crude oil. The upcoming implementation of the 7th Central Pay Commission awards adds to the adverse inflation dynamic. There is also the rise in inflation expectation of households and corporates. Stickiness in retail inflation (excluding food and fuel) is equally a matter of concern and raises the risks of higher inflation trajectory.

Second, the past policy repo rate reductions have not fully translated into the credit market in terms of reducing in lending rates. The transmission remains a concern but the RBI has hoped that this will improve in the light of reforms in the small savings rate, which has become market related, and the refinements in the liquidity management framework. This will pave the way for more transmission to support the revival of growth. It must be noted that the RBI reduced as much as 150 basis points earlier in the year.

What has emerged in this policy is a true central banker stance: working towards long term non-inflationary growth by keeping the eyes open to a range of uncertainties while at the same time working with an accommodative monetary policy. This in spirit is a reiteration of RBI’s stance, which is less concerned with the swings of today and more with the longer term trajectories that can have lasting impact.

But the moot question is how the economy can move towards non- inflationary inclusive growth? Monsoons, supply constraints and global uncertainties are not new. Monetary policy is but one arm of economic policy to manage these pressures. It could possibly meet the challenges of aggregate demand management but it has its inherent limitations. When the source of inflation originates from supply shocks, the efficacy of monetary policy is severely challenged.  The answer is structural reforms. In India, it is high time the policy makers and authorities should rebalance the growth strategy between agriculture, manufacturing and services. The non- inflationary inclusive growth critically hinges on agricultural productivity.

The next policy is due on August 9. It is very likely that the stance will continue. It is a stance that needs the support of the government if we are to move slowly but surely towards a stable path of non-inflationary growth. Any compromise means that the monster of inflation will continue to take its toll on the weakest and most vulnerable sections of India. We are on a disinflationary glide path. This is a path that demands some sacrifice of growth in the short term but works as the surest booster of growth in the long term.

(Dr. R.K.Pattnaik is Professor at SPIJMR. Jagdish Rattanani is Editor SPJIMR)