The Mismatch Between What MPC Says And What RBI Does

Bloomberg Quint, January 21, 2019

Under the new inflation targeting regime in India, the Monetary Policy Committee decides the repo rate and conveys the monetary policy stance. Both decisions are communicated through the monetary policy statements published on the Reserve Bank of India website six times a year after every meeting of the MPC. There are concerns, however, with the way the MPC has been conveying its monetary policy stance, especially recent times.

First, it helps if all inflation-targeting central banks, including the RBI, use the same language. This would facilitate a clear understanding on the part of stakeholders and also enable comparison across countries. The MPC has adopted some very unusual language to convey its policy approach. The ‘monetary policy stance’ typically refers to the current action of the central bank, whereas the MPC in India seems to be using it to signal future policy. Similarly, the world over, monetary policy stance is measured with respect to the neutral rate of interest. A ‘neutral’ stance means that the interest rate is at the neutral level, where the central bank is neither trying to push inflation down nor encouraging it to increase. The MPC however, seems to use ‘neutral’ to describe its attitude toward adjusting interest rates in the future.

Even there, the action taken does not seem to match the announcement. For instance, in the Aug. 1, 2018 meeting, the MPC retained its erstwhile ‘neutral’ monetary policy stance but raised the repo rate by 0.25 percent from 6.25 percent to 6.5 percent. In the next meeting on Oct. 5, 2018, the MPC changed its stance to ‘calibrated tightening’ but maintained the status quo on the repo rate. The adoption of a tightening stance may have hinted at a gradual increase in the repo rate over a period of time. Yet at the following meeting on Dec. 5, 2018, the MPC retained the ‘calibrated tightening’ stance. In addition, it left the repo rate unchanged and reduced the inflation forecast, hinting that rates might actually be cut in the future.

These instances show that the announced monetary policy stance of the MPC does not have anything to do with either the current or the future interest rate decision.

Finally, the monetary policy stance officially communicated by the MPC through the statements is often found to be in conflict with the actions taken by the RBI. The contradiction between MPC’s communication and RBI’s action points to a deeper problem about the conduct of monetary policy in India.

RBI’s Toolkit Working At Cross-Purposes?

There are three distinct instruments using which monetary policy can be conducted in any country. These are the short-term policy rate (in case of India, the repo rate) which is a price-based instrument, the cash reserve ratio and the open market operations by the central bank. The last two fall in the category of quantity-based instruments. In addition to CRR, in India, we have another quantity-based instrument which is the statutory liquidity ratio. SLR specifies the percentage of government securities that scheduled commercial banks are mandated to hold.

1. The effect of changes in the repo rate gets transmitted to the real economy through the bank interest rate channel.
2. The effect of changes in the quantity instruments get transmitted through the credit channel.
3. A reduction in the CRR or SLR or injection of liquidity through an open market purchase of government securities by the RBI are expected to result in an increase in the volume of loans disbursed through the banking sector, assuming that the channel of transmission works.

Ideally, the price-based and quantity-based instruments must operate in the same direction to reinforce the effect of monetary policy.That is not always the case in India. For instance, at the meeting of Aug. 2, 2017, the MPC announced a monetary policy expansion and the repo rate was lowered by 0.25 percent from 6.25 percent to 6 percent. Yet through the months of August and September 2017, the system was kept in a liquidity deficit mode. In fact, RBI conducted a cumulative open market sale of Rs 40,000 crore during these two months. An open market sale by RBI is akin to a monetary policy contraction.

At the last monetary policy meeting on Dec. 5, 2018, the MPC retained a ‘calibrated tightening’ stance. Around the same time, the RBI announced in its ‘Statement on Developmental and Regulatory Policies’ that it will reduce the SLR by 0.25 percent every quarter starting Jan. 2019, until the SLR reaches 18 percent of the net demand and time liabilities of the banks. Lowering of the SLR frees up liquidity which the banks can use to make loans.

This is tantamount to a monetary policy easing action which contradicts the ‘calibrated tightening’ stance communicated by the MPC.

During the period from June 1, 2018, to Oct. 5, 2018, when the MPC maintained a ‘neutral’ monetary policy stance, RBI injected Rs 40,310 crore through outright open market purchases. During the period from Oct. 5 2018, to Dec. 31, 2018, when the MPC changed its stance to ‘calibrated tightening’, RBI injected double the previous amount, Rs 1,36,002 crore into the system using OMOs. This shows that the monetary policy stance of the MPC contradicts the liquidity management operations of the RBI.

Poor Communication = Poor Transmission

The lack of symmetry between communication and action leads to confusion among financial market participants and distorts their inflation expectations. When the RBI injected liquidity using OMOs during the October-December 2018 period, the yields on government securities went down. One may argue that had the MPC’s communicated stance been in sync with RBI’s liquidity management action, the bond yields would have gone down further. G-sec yields are a crucial factor in determining the overall cost of capital in the economy. Lower yields could have benefited a stagnant private corporate sector.

The confusion caused by this inconsistency also weakens monetary policy transmission.

For quite some time the RBI has been concerned about the poor state of monetary transmission in India and has been experimenting with ways to link the interest rates charged by the banks to external benchmarks such as the repo rate. A relatively easier way to improve transmission would be to conduct the RBI’s liquidity management operations in sync with the MPC’s monetary policy stance.

The hallmark of a successful inflation-targeting regime is the anchoring of inflation expectations. Monetary policy communication can be used as an effective tool to influence the inflation expectations of private sector agents. The credibility of communication crucially depends upon the consistency between the message conveyed and subsequent action taken.

In absence of this consistency, the MPC’s communication loses its effectiveness.

This is particularly damaging for a new inflation-targeting regime such as in India where the MPC needs to build and establish its credibility. To achieve credibility and accomplish their goals, the RBI and the MPC need to start using standard language and eliminate the contradiction between the announced stance and the actual policy actions. In addition, the RBI needs to adopt a uniform strategy for conducting monetary policy, one that is symmetric across both price and quantity instruments.