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The central bank's rate reduction is consistent with its infl ation targeting approach.
Many were surprised on 29 September when the Reserve Bank of India (RBI) reduced the policy repo by a hefty 50 basis points. However, a reading of the earlier policy statements and several parallel changes that the Governor of RBI, Raghuram Rajan, has been making in the monetary policy framework and operating procedures will reveal how the central bank has been consistent in its agenda ever since Rajan assumed office in September 2013.
Even while the policy framework in terms of the constitution and powers of a regular monetary policy committee is yet to be finalised in consultation with the government, a strong inflation targeting approach has got entrenched with Rajan in office. The RBI Governor strongly believed even earlier that the primary objective of a central bank was inflation control or price stability since sustainable growth could not be achieved without containing inflation. Therefore, policy rate changes are now mainly guided by how the inflation projection falls in line with targets. At least three of the previous RBI Governors, D Subbarao, Y V Reddy and Bimal Jalan, did not believe in a rigid inflation targeting framework in the Indian context and explicitly stated that it would not work in Indian conditions. They followed, instead, the multiple indicator approach from 1998 to 2013. Though inflation control has been implicit in RBI’s policy framework since its inception, Raghuram Rajan has now made it very explicit.
Forward guidance has become a regular feature of policy announcements under the new approach and the repo rate reduction is very much in line with the guidance given earlier. The Monetary Policy Report of September 2015 has clearly stated,
In India, forward guidance has served the purpose of guiding market expectations around monitoring the sources of and risks to inflation. Given the uncertainties surrounding time varying output gap estimates, the evolution of exogenous factors driving the inflation process, global spillovers, and the nature, size and timing of measures undertaken by the Government to contain inflation, forward guidance has to be conditioned by incoming data.
It is this “conditional” forward guidance that makes RBI’s inflation targeting a flexible framework. But if the RBI is made fully accountable for maintaining inflation targets as is proposed now, the central bank may run the risk of policy credibility. It would therefore be advisable, as part of the proposed new framework being finalised with the government, for the RBI to keep an exit route and define some necessary and sufficient conditions for successful inflation control under varying circumstances. Two such essential conditions would be the supply-side factors that are not under the control of RBI and that the fiscal rules are fully complied with by the government.
Yet another area of innovation since 2013 is in the way the Liquidity Adjustment Facility (LAF) along with other liquidity measures have been augmented. While the limits in terms of net demand and time liabilities have restricted the abuse of the LAF, a combination of fixed rate and auction repos of overnight and term durations, along with the marginal standing facility and open market operations have smoothened the process of keeping the weighted overnight call money rate and other short-term money market rates in alignment with the corridor set by the RBI. These operations are also perhaps attuned to foreign exchange operations that steer the exchange rate of the rupee consistent with macro fundamentals.
While policy transmission to the money market has thus been handled successfully, transmission to credit and bond markets remains less than complete. The forward guidance of September states that while the RBI’s stance will continue to be accommodative, the focus of monetary action in the near term will shift to working with the Government of India to ensure that impediments to banks passing on the bulk of the cumulative 125 basis points reduction in the policy rate are removed. The fact is that the cumulative 75 basis points cut in the policy rate until now has had an impact on bank lending rates only to the extent of 30 basis points. While banks may be quick to respond when rates rise, they are sluggish when rates fall since they are keen on maintaining net interest margins. This may be more so under current conditions of a huge build-up in non-performing loans. Since public sector banks are the major culprits, perhaps the RBI wants to rope in the government for successful transmission. But why should RBI subordinate its supervisory powers to the government, something which runs counter to its operational autonomy?
There are a few more issues looking forward. First, utterances of the senior management of the RBI in their interaction with media and researchers on the real interest rate have caused some confusion. While the projected 91-day Treasury Bill rate was referred to in relation to the repo rate, on another occasion, it was related to long-term interest rates. One question is whether a real rate of, say, 1.5% to 2.0%, as considered appropriate by the RBI, is relevant only at the current juncture or the policy rate adjustments in future will also be contingent upon the emerging scenario in real interest rates. This would mean inflation targeting will be combined with real interest rate targeting.
Second, given the accommodative policy stance, the policy rate may see further downward adjustments. Will it go down up to 6% in alignment with the inflation target/projection pointing to another 1 percentage point reduction by 2017? Will a lower interest rate by itself not generate inflationary pressures through expansion in economic activity, once the available slack in terms of excess capacity is exhausted? How will the turn in inflation cycle be handled and how will it be timed? These are the interesting things to watch.
