MPC Meet: Existential Questions For RBI And India’s Monetary Policy Committee

The pandemic has upended three pillars of monetary policy. The fourth pillar — RBI — is holding the fort, like in the old days.

Shaktikanta Das, governor of the Reserve Bank of India  pauses during an interview  in Mumbai. (Photographer: Kanishka Sonthalia/Bloomberg)
Shaktikanta Das, governor of the Reserve Bank of India pauses during an interview in Mumbai. (Photographer: Kanishka Sonthalia/Bloomberg)

India’s monetary policy framework has been an evolving one. From a time when the bank rate held pride of place to a policy rate corridor, book-ended by the repo and the reverse repo rates. In 2013, a panel recommended a move to a single policy rate defined by the repo rate. This, then went on to become the single tool for the Monetary Policy Committee with a flexible inflation mandate of 4%, within a comfort band or +/-2%.

The pandemic has upended each of these three pillars. The fourth pillar —the institution of the Reserve Bank of India and the office of the Governor — are holding the fort, much like in the old days.

Will The Real Policy Rate Please Stand Up

For more than a year now, the repo rate has ceded supremacy to the reverse repo rate as the benchmark. The former, currently at 4%, is the rate at which the RBI supplies liquidity to the banks, while the latter, at 3.35%, is the rate at which liquidity is absorbed by the central bank.

After the Covid-19 crisis hit, the RBI flooded the system with liquidity. Sixteen month later, banks are parking close to Rs 5-6 lakh crore with the central bank. Core liquidity, which is headline liquidity plus government cash balances with the central bank, is at an all-time high of near Rs 10 lakh crore, according to QuantEco Research.

All this has meant that short-term funding rates remain below the formal policy rate, i.e. the repo rate of 4%. The 91-day treasury bill rate at the last auction was at 3.38%, the 182-day at 3.52% and the 365-day at 3.73%.

They were running even below the reverse repo rate of 3.35% for a period of time but that anomaly was corrected after the central bank reintroduced the variable rate reverse repo operations.

With the floor on rates being set by the reverse repo rate, the market is now waiting to see how soon the RBI (not the MPC) will lift the reverse repo rate. Far less attention is paid to any expected change in the repo rate, which many expect is still some time away.

The Evolution Of Interest Rate Benchmarks In India

MPC: RBI + 1

The change in focus away from inflation and the policy repo rate — for good reason perhaps— has meant that the Monetary Policy Committee has become a ‘plus-one’ to the RBI.

Ever since the crisis hit, the RBI has done much of the firefighting after the initial rounds of interest rate cuts delivered by the MPC. The liquidity policy, the level of the reverse repo rate, the decision to keep a cap on market rates by expanding and rebranding the government bond purchase policy and the directed credit tools are all policies designed by the RBI.

The MPC, meanwhile, only votes on the repo rate, which has remained unchanged since May 2020. A debate over whether at least the reverse repo rate, if not some elements of the liquidity policy, should be put on the MPC’s discussion table has come and gone with no change.

Some argue that’s for the best as RBI is better placed to make these decisions and move quickly. Others say it diminishes the role of the MPC.

While the Covid crisis may have forced some of this change, remember that the shift had become visible even before that as the MPC had refrained from bringing down rates due to inflation concerns, while the RBI moved on growth-supportive measures. At the time, when BloombergQuint asked Governor Shaktikanta Das of the potential disconnect between the MPC and the RBI, his response was telling. “The MPC has a defined role, within that defined role, the MPC is supreme,” Das had said.

Now as inflation remains close to the upper band of the inflation target of 4 (+/-2)%, even as the RBI continues to see economic conditions as fragile, some of those tensions may potentially return.

MPC Meet: India's Inflation Dilemma Mirrored Across Peer Economies

Is The Inflation Target 4 (+/-2)% Or 2-6%?

The final issue, and perhaps the most tangible one of the three, is the inflation target.

For the past two months, retail inflation has been above 6%. That’s the upper bound of the 4 (+/-2)% flexible inflation target. The RBI hopes it will fall to below 6% and average 5.2% in FY22.

That still remains well above the 4% mid-point.

Recall here that it took a fairly lengthy battle to establish the need to bring inflation down to 4%. While many had opposed it, the camp of inflation targetters had eventually prevailed and hence the target had been defined around the mid-point of 4% as opposed to just 2-6%. Implicit in the framing of that target is the need to move toward 4% inflation, eventually and over the medium term.

But for 21 months now, inflation has stayed above 4%, pointed out Pranjul Bhandari, chief India economist at HSBC in a note this week. “Several inflation drivers have come and gone. But inflation has stayed elevated, like a chameleon, adapting itself rather quickly to the driver of the day.”

To date, there are supporters and detractors to the 4% target.

Ahead of a review of that target earlier this year, the RBI’s research division had backed it, saying that trend inflation has fallen to a range of 3.8–4.3% during the period of flexible inflation targeting, indicating that 4% is the appropriate level of the inflation target for India. “Threshold inflation above which growth is unambiguously impaired ranges between 5 and 6% in India, indicating that an inflation rate of 6% is the appropriate upper tolerance limit for the inflation target.”

A counter-point had come from former MPC member Ravindra Dholakia. A paper he co-authored with Jai Chander, Ipsita Padhi and Bhanu Pratap, had pegged the threshold level of inflation at closer to 6% and optimal growth at 7.5%. “If we consider the inflation target at 4% instead of the threshold level of 6%, the long-term growth rate would decline by about 80 basis points,” the study had said.

That debate not withstanding, 4 (+/-2)% is the legal mandate. As the Covid crisis ebbs, will the MPC seek to reinforce that mandate in letter and spirit?

Some members may see the need to do that. “The MPC has been able to maintain monetary accommodation in the face of above-target inflation mainly because of its hard-earned credibility for successful inflation targeting. To maintain and enhance this credibility, the MPC needs to remain data driven so that it can respond rapidly and adequately to any unforeseen shocks that may arise in future,” said member JR Varma, according to the minutes of the last meeting.

That statement that may prove prescient in the coming months if inflation prevails.

Ira Dugal is Executive Editor at BloombergQuint.