India’s monetary policy architecture has undergone a transformational upgrade in the last 2-3 years. The adoption of a flexible inflation targeting framework, nurturing of the term money market, migration towards a neutral liquidity regime, and a committee based collective decision making (via Monetary Policy Committee) have heightened key elements of accountability and responsibility.
Monetary policy is typically the first line of defense against both domestic and global shocks. The policymakers in India have indeed taken a great stride in fortifying this critical mechanism. However, emerging market economies (EMEs) face a number of challenges due to the nature of their underdeveloped financial markets, relatively low per capita incomes, prevalence of poverty, institutional rigidities, vulnerability to global contagion shocks etc.
Keeping in mind the multitude of factors involved, the existing monetary policy framework can be fine-tuned further according to domestic conditions to enable it to achieve the desired policy objectives. From a practitioner’s perspective, the following four steps can be critical in imparting efficiency to the Indian monetary policy framework.
Move from ‘calendar anchor’ to ‘average anchor’
In the current monetary policy dispensation, RBI targets the end period CPI inflation, which pertains to the month of March. While this fixation with calendar can work well for developed economies where inflation volatility is low, for EMEs like India that are often susceptible to random and transient price shocks, sticking to a calendar target can be ineffective. In contrast, the average annual inflation that smoothens out the seasonal and random price vicissitudes can offer a superior anchor as a policy target.
Be nimble on neutral rate
The concept of neutral interest rate is akin to the unobservable real rate that keeps inflation stable (or at target) when the output gap in the economy is zero. Globally, the neutral rate in developed economies has been drifting lower due to the combined impact of ageing population, debt overhang, low productivity growth, etc.
In its October monetary policy review, the RBI lowered its minimum threshold for the neutral rate to 1.25% from 1.50% earlier. This is not surprising and is an excellent proactive measure. In this globalised environment, India cannot remain immune from structural changes in the trajectory of neutral rate for long. While structural reforms like the GST and Bankruptcy Code will boost growth potential in the medium to long term, lukewarm investment appetite amidst the twin balance sheet problem in India has curtailed the short term growth potential despite immense opportunities on the horizon.
A somewhat lower neutral rate of 1% would be consistent with the current state of the Indian economy characterised by gradual disinflation and a negative output gap. Assuming CPI inflation averages around 4.7-4.8% in FY17, a 1% neutral rate would warrant the 1-year Treasury Bill yield to be around 5.7-5.8% (4.7-4.8% + 1%) vis-à-vis 6.4% currently. Further, the recent demonetisation drive initiated in the economy, could further induce disinflation. This would imply 100 bps space for incremental monetary easing over the next 6-12 months.
With the government walking-the-talk on food supply management, and hence helping to keep inflation below target, the central bank in my opinion can exploit this comfortable phase and get nimble footed on neutral rate to support growth conditions. Over the course of the business cycle, the neutral rate can be gradually adjusted upwards once output gap turns positive from negative.
Making liquidity consistent with monetary policy stance
Since April, the RBI has migrated to a neutral liquidity framework from the deficit regime earlier. In a neutral liquidity framework, the banking system on an average has close to zero overnight borrowing from/lending to the RBI. This is a welcome change.
However, neutral liquidity cannot be independent from the concept of a neutral rate. If the existing interest rate is higher than the neutral rate, then the stance on liquidity and the monetary policy should both be accommodative.
The current scenario is characterised by an accommodative monetary policy stance. In my opinion, this should be complemented with an accommodative stance on liquidity as well with policymakers using their discretion on the appropriate magnitude of liquidity surplus. The durable liquidity, in fact, is now bound to make way into the economy with a structural moderation in currency in circulation, post the demonetisation of R500 and R1,000 currency notes. This can be further supplemented by 100 bps reduction in the CRR to its long term target of 3% in a phased manner. This cut in CRR would reduce statutory pre-emption and unlock over R1 lakh crore that could help in partially reducing balance sheet stress in PSU Banks while also contributing towards productive lending.
Sceptics can argue that such a policy can interfere with the monetary policy stance, as this could result in call money rate immediately falling by 50 bps (i.e., a shift from repo rate to reverse repo rate). Such misgivings are misplaced in my opinion. With RBI having developed the term money market, a calibrated use of term reverse repos in a liquidity surplus environment can reduce the overhang and still keep call money rate close to the policy repo rate.
The collateral benefit of such a move would shrink liquidity risk premium in the money market and provide a significant boost to monetary policy transmission mechanism and the bond market.
Active calibration of macroprudential policies
The global community is slowly realising the limits of monetary policy. An active usage of macroprudential policies, especially for EMEs, can help preserve the degrees of freedom for monetary policy.
RBI has done well in accumulating forex reserves as a macroprudential policy for future financial market stability. A further use of macroprudential policy can be with respect to calibration of sectoral risk weights to drive the broader policy objective. For example, lowering of risk weights for funding developers for Affordable Housing projects can help in channelizing adequate credit flow to this sector over a period of time, thereby helping in planned urban development and also benefitting government’s Smart City Project.
The above mentioned contouring of the monetary policy framework can help the overall architecture get attuned to domestic conditions. In conjunction with the anticipated version 2.0 of the FRBM armature, I believe the monetary and fiscal policies can create positive externalities for our economy by maximisation of synergies.
The author is MD & CEO, Yes Bank. Views are personal