Setting monetary policy with mixed signals

Setting of interest rates is a key component of the monetary policy. This responsibility is now with the Monetary Policy Committee (MPC). The MPC has six members, including the governor of the Reserve Bank of India, and each member has one vote. In case of a tie, then the governor has an additional vote. Note that the governor does not have a veto to override others.

The MPC arose out of a formal agreement signed between the Government of India and the RBI in February 2015. That agreement, subsequently given legislative basis through an amendment to the RBI Act of 1934, basically gave a sharper mandate to the RBI.

For the past two years, the RBI’s primary mandate had been to keep inflation low and stable, and it achieves this through the instrument of interest rates. The key policy interest rate, called the repo rate — the rate charged by the RBI to all banks who borrow emergency funds from it — is set by the MPC. 

Remember, the RBI is a lender of the last resort, and hence the repo rate is the basis of all short-term rates in the economy. To the extent that short-term rates are linked to long-term rates (such as for home loans or loans to corporates), the repo policy rate is what determines the interest rate structure in the country.  Hence, the role of MPC is critical.

In the June 7 monetary policy decision, the MPC chose to keep the policy rate unchanged. This disappointed many people who were expecting a reduction in the rate. One of the vociferous discontents was the government itself. The chief economic adviser to Finance Ministry said that the RBI was making large errors in inflation forecasting and was systematically overstating inflation.  
He said that the rupee was getting stronger, we have had a good monsoon and oil prices remain moderately low.  He implied that not cutting rates now was hurting investment and growth. Such criticism of the MPC came from other quarters as well, such as economists, editors and chambers of commerce.

So let’s examine how valid is this criticism. Firstly, even if the MPC has not cut rates, its commentary has turned dovish. Meaning it is open to a rate cut in the future, possibly as soon as August. Secondly, it is operating the Monetary Policy Framework agreement that was signed back in 2015, which basically is a flexible inflation-targeting framework. The current “target” is actually a band of inflation between 2% and 6%.

The latest CPI based inflation reported for April was 2.99, well within the band. Thirdly, we have a new source of possible risk to higher inflation. This is through fiscal pressure of the epidemic of loan waivers.  The GST might also be initially inflationary.

Fourthly, if the government wishes interest rates to be lower (of which it itself would be the prime beneficiary, because it is the largest borrower), then it should set a higher inflation target. As per the agreement, the government gives a target to MPC and MPC achieves that target through its instrument of interest rates.

The government cannot target the interest rate directly.  That is not in the agreement. In its wisdom, the MPC has determined that the current target can be achieved by keeping the repo rate unchanged for now. If parameters, macroeconomic conditions change, then the rate may have to be changed.

That’s why the MPC meets every two months for frequent review. It cannot also be seen as simply swaying with the wind and taking knee-jerk decisions. The MPC takes inputs from everybody, including academics, industry bodies, depositors’ associations, and also the government.
There was a minor kerfuffle prior to this past week’s meeting. The government desired to meet the MPC on the eve of its meeting, to convey inputs via a three member panel. The press reported that the MPC had been “summoned” to Delhi. This is most unusual, and against the spirit of the agreement signed between RBI and government. 

No overt pressure

Thankfully, the MPC flatly refused, and government also possibly withdrew the “summons.” The MPC mechanism is a robust improvement over the earlier mechanism where one person — the RBI governor — would take the call. But then and now, it was and is important to let monetary policy function without any overt “pressure.”

The RBI is neither a constitutional body nor is it autonomous. It is the creation of an Act of Parliament. But never in its 82-year history has the government interfered with interest rate policies. Such a solid reputation for credibility, independency, and integrity is precious and built over a long time. Sure, many monetary policy decisions can be faulted or criticised post facto.

But there are legitimate avenues for these, and of course methods for course correction. But interference is to be avoided at all costs. As it is, there is anyway a formal meeting of the governor and the Finance Ministry prior to the monetary policy as per tradition.  

Now that the MPC is functioning, we need to strengthen it with timely and appropriate interventions, not interference. Inputs, not instructions, are the thumb rule. As such, right after the MPC’s latest decision, the deputy governor admitted that the RBI’s inflation forecasts need to be more robust and reliable. Also, in a world of extreme and rising volatility, who can blame forecasters? It is also worth recalling that the RBI is an institution that is supposed to take the punch blow away, just as the party gets going.

Of course given current macro data, the economy is not exactly having a party. But neither is the RBI behaving like a party pooper. The revival of private investment spending, resolution of banking NPAs, job creation at a more rapid scale, and more momentum to infrastructure, affordable homes and Make in India, all call for not just lower rates but plenty of other policy interventions. The MPC is just part of a larger jigsaw. Let it be.

(The writer is an economist and Senior Fellow, Takshashila Institution)
(The Billion Press)