Column: Keep the markets guessing

Written by Madan Sabnavis | Updated: Mar 22 2014, 08:45am hrs
The scope of a monetary policy statement has changed over the years. From the conventional slack and busy season policies, we have moved to multiple policy reviews, 8 times a year under former RBI Governor D Subbarao and now 6 times, under Governor Raghuram Rajan. In the earlier versions, the policy was comprehensive and covered all aspects of the financial sector including debt markets, credit delivery, urban banks, and prudential regulation and so on. Even when we had more frequent reviews, the quarterly reviews were all-encompassing.

RBI, however, retained the prerogative to intervene between two scheduled policy reviews if it was warranted, quite like in 2013 when the LAF facility was modified and the MSF rate was hiked. While the idea of having multiple reviews more frequently was to lower the noise factor, it may have made policy that much less effective as the market appeared to be ahead of the policy change. This is a conundrum which still needs to be resolved. Surprises can cause an upheaval in the bond market and affect the valuation of over R65 lakh crore of government securities. On the other hand, anticipated changes tend to silently pass by the impervious market once it has already been buffered.

Further, by having separate committees look at various aspects of the markets, we have actually spliced the policy and differentiated between monetary policy action and regulatory and systemic issues. Each of these subjects have been dealt with separately thus making monetary policy a pure monetary affair. Therefore, monetary policy will be about interest rates and nothing else. This becomes similar to what central banks do globally where only interest rates are spoken of in the context of growth, employment, and inflation.

To put the policy stance in perspective, a backdrop of the global forces and the state of the domestic economy becomes relevant so that one can understand the rationale behind the central banks moves. This, sort of, prefaces the policy while explaining the proposed action. Invariably, there is a call taken on how the economy would be behaving and what the price situation is likely to be going ahead.

If one were to put a theory to the current wave of thinking on Mint Street, then there appears to be a movement towards a pattern of surprise. The number of policy reviews has been reduced to 6 from 8. Also, since September, there has been no pattern in policy action though broadly we are aware that CPI-inflation matters more. This appears again with the line of thinking in countries that monetary policy should target inflation first and growth becomes secondary. In the past there was some vacillation between headline WPI-inflation and CPI-inflation and food inflation and core inflation. But now, it appears to be certain that we would be moving towards the global trend of targeting CPI-inflation. There is acceptance of the Urjit Patel Committee Report, which means that the CPI will matter more.

The accompanying table provides the signals that were available to RBI when a policy decision was taken based on the releases on CPI and WPI.

The table shows that it is hard to discern a pattern based on past action, as RBI has kept the market guessing all the time. Implicitly, RBI has taken into account the concept of inflationary expectations while deciding on its policy stance. Also, given that interest rates do not affect the components of the CPI, monetary policy will be reactionary to inflation, meaning that as long as retail inflation is high, so will interest rates. Therefore, one can surmise that we are looking somewhere at real interest rates. The concern is palpable on the retardation in financial savings in recent times.

What then can we expect RBI to do this time Logically, if inflation was the cause and has come down, then there is definitely no case for increasing rates further as was done last time. But as CPI-inflation is still above 8% which was what RBI appears to have targeted for January 2015, it could mean that the time has not yet come to lower interest rates. Besides, one is not sure of the crop damage on account of the recent unseasonal rains, which could put some upward pressure on prices.

Add to this the talk of a possible El Nio effect which can upset the monsoon movements and eventually food prices, there is a strong argument for status quo. In fact, any change in monetary stance should ideally be consistent with the final borrowing programme of the government which will be known only when a new government is in place and a Budget is drawn up.

But, given the predilection so far for surprising the marketswhich is also what the Rational Expectations story book, a la Thomas Sargent and Neil Wallace, advocateslowering rates at this time would be a pleasant surprise. More so because it is not being expected given the market interpretation of RBI's thought process based on past monetary policy statements. On the flip side, it could just be interpreted as a prelude to the elections if rates are lowered.

The author is chief economist, CARE Ratings. Views are personal