Rajeev Malik: The RBI's smoke and mirrors
The Reserve Bank of India’s (RBI’s) mid-year review on October 30 was an anticlimax. But not because it kept the policy rate unchanged at eight per cent — that is its prerogative based on the assessment of the macro trends. The policy was an anticlimax because it was contradictory and confuses more than it clarifies. Indeed, it is the latest evidence that confirms that the central bank’s walk has not been following its hawkish talk, and that a stealth easing has already been in place.
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The RBI raised its inflation forecast but cut the GDP growth forecast. The combination of below-trend growth and above-trend inflation is not new, and it only underscores the abnormal economic cycle that India is experiencing. It eased policy by announcing a cut of 25 basis points in the cash reserve ratio (CRR), to a record low of 4.25 per cent, but refrained from cutting the policy rate, citing concerns on inflation. But, and this takes the cake, Governor D Subbarao signalled the possibility of easing in the January-March quarter of 2013, thereby compromising the effect of keeping the repo rate unchanged.
To be fair, there are several areas where the central bank’s fight against inflation has been compromised by the government’s inadequate constructive response, especially on fiscal correction. But equally importantly, the RBI’s holier-than-thou attitude of putting the onus entirely on the government is not the complete story. The central bank should do some introspection as it’ll discover that some of the reasons for its failure to fully rein in inflation rest with its approach.
Any central bank would ease monetary policy as inflation improves. But the RBI went out of its way to emphasise the probable timing of its anticipated easing — hardly any central bank offers such guidance. The job of a central bank is not to tell the markets what and when it is going change monetary policy. It is to ensure that its monetary framework and markers are consistent and well understood, so that investors alter their expectations of the central bank’s response function depending on the incoming data signals. However, the RBI has not been successful in offering this clarity despite communication that is more frequent and also spans more channels of dissemination. It needs to better appreciate that more frequent communication is not always better — if it is inconsistent and adds to uncertainty.
There are three puzzling aspects of the RBI’s approach. First, several economists have praised the RBI for standing up to the government pressure to cut rates but have been supportive of the cut in CRR. Now, this praise is actually unwarranted. It would have been justified if the RBI had kept its policy unchanged. But that was not the case; the central bank eased policy despite its hawkish talk.
It is often overlooked that a CRR cut is more potent than a repo rate cut, as the former affects liquidity in the banking system immediately. The RBI could have cut the repo rate keeping the CRR unchanged, or cut the CRR while keeping the repo rate unchanged (less frequently, both could be cut). Both combinations amount to monetary easing, but the transmission could vary. There is a widely prevalent misperception in India that since repo rate is a signalling policy rate, keeping it unchanged but cutting CRR somehow still indicates a hawkish stance.
Nothing could be further from the truth. In fact, given the significant decline in certificate of deposit (CD) and commercial paper (CP) rates because of a combination of softening credit demand and easing liquidity, the repo rate is now out of line with them. Indeed, in the coming months, the repo rate will be following the market rates rather than leading them, all thanks to the RBI’s efforts to ease liquidity conditions while staying put on the repo rate.
Ironically, the main entity that benefitted from the CRR cuts and open-market operations (OMOs) is the government. This is because bond yields have been well supported despite the fiscal slippage and sticky inflation. Fiscal profligacy is a key reason for India’s inflation problem. However, the RBI’s actions have kept interest rates high for the private sector but have lowered the cost of borrowing for the key culprit, that is, the government — which is also the most price-insensitive borrower.
Second, the RBI has frequently changed the importance it places on different inflation yardsticks. It has formally announced forecasts for only the headline wholesale price index (WPI) inflation, but it has also used WPI-core and consumer price index (CPI) inflation rates for justifying its monetary stance. High food inflation, too, has been used to support a tight monetary stance because of concerns over its effect on inflation expectations. Finally, there have also been instances when the sequential pace of seasonally adjusted inflation has influenced its policy decision. Such a varied approach throws off market participants, since it is unclear which trick the RBI is going to use next.
Third, surprisingly, for a central bank that kept the policy rate unchanged because of its inflation concerns, it explicitly wants banks to cut their lending rates. In fact, one of the expected outcomes the RBI is hoping for from its policy is that it will “...enable liquidity conditions to facilitate a turnaround in credit growth to productive sectors so as to support growth". In such a setting, it is confounding how keeping the repo rate unchanged helps the fight against inflation, since the RBI wants to improve aggregate demand through lower lending rates.
The underlying liquidity conditions are not as tight as they are made out to be especially by banks, which are talking their own book. Banks indicate weak credit demand and complain about tight liquidity. But they have been buying government bonds to increase their ownership of these to be well above the mandatory statutory liquidity ratio of 23 per cent. Just looking at banks’ borrowing in the liquidity adjustment facility does not give the full picture of the broader system-wide liquidity conditions.
Monetary policy is a blunt tool, and only the RBI can know how it will ensure credit to productive sectors by keeping the repo rate unchanged. It is true that the RBI has to deal with several constraints, some of which are fallout of government inaction. Consequently, monetary policy alone cannot be the lasting solution to India’s inflation. Still, the RBI will achieve better success if it comes across as being less confused about what it is trying to fix: low growth or still-high inflation. In the absence of such clarity, it’ll have little success, as has been the case.
The writer is senior economist at CLSA, Singapore.
These views are personal