MPC Minutes Reflect Long Road Ahead For Monetary Policy

India's Monetary Policy Committee believed that more rate hikes would be needed to quell inflation pressures, which, in turn, would mean some degree of economic pain, showed minutes of its June meeting released on Wednesday.

The committee has hiked the benchmark repo rate by 50 basis points early this month—its second increase in two months. It had first raised rates by 40 basis points at an unscheduled meeting in May.

The time is appropriate to go for a further increase in the policy rate to effectively deal with inflation and inflation expectations, RBI Governor Shaktikanta Das said in his statement.

"...while high inflation continues to be the major concern, revival of economic activity remains steady and is gaining traction," Das said while voting in favor of the 50 basis point increase and a change in the committee's stance.

The governor, however, pointed out that the repo rate is still below the pre-pandemic level and the liquidity surplus is still higher than what it was prior to the pandemic.

Explaining the change in stance, Governor Das said it will provide greater clarity on our policy intent by focusing wholly on the withdrawal of accommodation. "As our policy in recent months has been unambiguously focused on withdrawal of accommodation, both in terms of liquidity and rates, the change in wording of stance should be seen as a continuation and fine-tuning of our recent approach."

The withdrawal of accommodation, Das said, would be non-disruptive to the process of recovery and would strengthen ongoing efforts to combat inflation and anchor inflation expectations.

In the process of modulating demand by the monetary policy, spending will slow down, so will demand and so will the economy, Deputy Governor Michael Debabrata Patra said. This, Patra said, was unavoidable as supply needs time to catch up with demand.

"To gain time for supply to respond, the blunt instrument of monetary policy has to be deployed – there is no other recourse at this juncture," he said.

According to Patra, the objective should be to take the repo rate to a height that is at least above the four quarters ahead forecast of inflation, knowing that monetary policy works with lags. It is important to condition public perceptions and expectations that growth will be closer to 6% than to 7 % in 2023-24 as a result of monetary tightening, he said.

But if inflation is allowed to go out of hand, it could corrode the foundations of the recovery that is gradually gaining traction, deter investment decisions, cause depositors to worry about negative returns to their deposits, cause exchange rate depreciation which will increase imported inflation, discourage capital inflows and trigger large capital outflows, Patra explained.

"So, the die is cast."

Patra, however, said that Inflation may be peaking. Excise duty cuts on fuel products will knock-off 20 basis points from headline inflation. After that second-order effects will take effect.

As monetary policy works through its lags, demand will inevitably get restrained and become compressed to the level of supply. Inflation will fall back to below 6% by the fourth quarter of 2022-23. In 2023-24, it should moderate to 4%. This is the most pragmatic result that can be hoped for under the prevailing extraordinary circumstances.

"This is the most pragmatic result that can be hoped for under the prevailing extraordinary circumstances."

"While frontloading policy measures, one needs to be aware that the pace of policy transmission has quickened after the introduction of the external benchmark-based lending rates in October 2019," Rajiv Ranjan, executive director at the Reserve Bank of India, said in his statement.

With more than 40% of the total floating rate outstanding loans linked to external benchmarks, the degree of pass-through to actual lending rates has increased and this would strengthen monetary transmission in the current cycle, he said.

The inherent framework of the EBLR regime which enables quicker and larger transmission to lending rates coupled with banks’ propensity to pass-through policy rate changes to lending rates rather quickly, particularly during tightening cycles, may have to be factored to achieve the desired outcome during the current tightening phase. Of course, the trajectory of inflation will be an important determining factor, he said.

According to Ranjan, when monetary-fiscal coordination is at its best, fighting inflation becomes a joint responsibility, which is crucial for engineering successful disinflation. In this context, with monetary policy prioritising price stability and fiscal policy emphasising on quality of expenditure through capex, the economy becomes the net beneficiary.

"Thus, it may be important for the government—both centre and states—to successfully complete their budgeted capex plans and work through their counter-cyclical policy levers to ensure a soft-landing for the economy amid monetary tightening to rein in inflation."

Jayanth R Varma, in his statement in May, had called for more than 100 basis points of rate increases to be carried out very soon.

"Taking into account the 40 basis points hike in May, my preference would have been for an increase of 60 basis points in this meeting," he said. "However, I have decided to go along with the majority view of 50 basis points for the same reason as in May—a difference of opinion of 10 basis points is not material enough to be elevated to a dissent."

The MPC has a lot of catching up to do, Varma said. Between April and now, the MPC has raised the policy rate by 90 basis points, but during the same period the RBI’s projection of inflation for the year 2022- 23 has risen by 100 basis points from 5.7% to 6.7%. The real policy rate, therefore, remains more or less where it was in April.

"This reminds me of Lewis Carroll’s adage that we must run as fast as we can, just to stay in place, and to go anywhere we must run even faster."

Clearly, more needs to be done in future meetings to bring the real policy rate to a modestly positive level consistent with the emerging inflation and growth dynamics, Varma said.

As the MPC navigates this process of withdrawal, Varma said there is merit in signaling the likely pace of this tightening in more quantitative terms. Many leading central banks currently provide forecasts of the future path of the policy rate several quarters ahead.

The MPC has now accumulated several years of experience, and the RBI has evolved into a mature inflation targeting central bank. "I believe that the time is therefore ripe for MPC members to start moving towards providing projections of the future path of the policy rate. This would help stabilise long-term bond markets and anchor inflation expectations."

While some committee members argued for a move towards positive real rates, MPC member Ashima Goyal differed.

At the current stage of recovery, the one-year ahead real rate must not be more negative than -1%, she said.

A 50 or 60 basis point hike would achieve this, while looking through part of the spike in 2022 even as further supply-side movement and clarity on global developments are awaited, Goyal added. Such a real interest rate, while not dampening the recovery much, will prevent a possibly inflationary further rise in demand and unsustainable current account deficit.

Changing the course of inflation trajectory to reach targeted level is a priority at this stage for monetary policy although the growth momentum remains modest one, said committee member Shashanka Bhide.

Bhide argued that, in view of the elevated levels of inflation rates, there is a need to ensure that policy rates are consistent with the requirements of moderating inflation expectations and liquidity conditions are consistent with the requirements of economic growth in an environment less constrained by the COVID pandemic.

"While the impact of these measures is likely to have some adverse impact on aggregate demand in the short term, moderating inflation pressures now is crucial to ensure a stable macroeconomic environment," he wrote.