A monetary policy review normally attracts less attention than the first annual statement of policy for the forthcoming year, but Tuesday?s first quarter review is drawing heightened interest in RBI?s stance and its situational perception, given the ?unusually uncertain? global economy (as Ben Bernanke has articulated) and the unanticipated, persistent liquidity shortage that our domestic banking system has experienced since June. That RBI will continue with its ?baby steps? tightening approach is now virtually a consensus among interested observers, raising the LAF repo and reverse repo rates by 25 bps, while keeping the CRR unchanged, to achieve a balance between anchoring inflationary expectations and enabling credit delivery to productive sectors and hence growth.
But will it continue with the pattern of symmetrically increasing the rates, as it has done since November 2008? Or it might introduce a slight variation in the process, differentially increasing the repo and reverse repo rates, in order to narrow the LAF corridor, from the current 150 bps to, say, 125 bps and then 100 bps?
India is one of the increasing number of countries with a corridor type of policy, with standing facilities for both credit and deposit from the central bank, rather than the more conventional one based on open market operations. The width of the LAF corridor is based on the following considerations: first, what optimal level of money market volatility is consistent with money market objectives and yet enables sufficient price discovery? And, second, a view on liquidity, based on which end of the corridor becomes the operating rate and the main transmission channel for monetary policy.
The general principle in managing the width should logically be a narrowing during a tightening phase and a widening during an easing one, a principle consistent with the idea of fine tuning policy rate increases to have the desired impact with a smaller policy move. Ideally, overnight repo rates should be aligned to an operating band closer to the direction of the policy stance, e.g., the upper band during a tightening phase.
The corollary is obviously an estimation and projection of the appropriate level of system liquidity; too much would keep overnight rates near the bottom, requiring larger increments to push the overnight rate up to the policy rate target. The operative rate remains the repo rate, given the liquidity shortage, and it is the repo rate that is likely to be the predominant operating rate for most of FY11, given our expectations of liquidity. If this does indeed turn out to be the case, then the repo rate would be the effective ?neutral? rate, rather than a rate mid-point in the corridor, should liquidity ease gradually over the next couple of months.
This is obviously a simplified and abstract, if not simplistic, view of the decision process. In real life, money market conditions, the government?s borrowing programme, demand for bank and other credit, capital flows from abroad, growth of broad and reserve money aggregates, will all combine to determine the policy instruments.
What change in the operating environment might motivate such a move and will it have a material impact on the policy signals that it would seek to transmit to markets? A brief overview of the current economic situation might provide the context. It is now the increasing consensus that global economic recovery in developed countries will remain moderate, if not actually contract in a double-dip recession. This moderation will increase in 2011-12, as fiscal streamlining begins. China is attempting a moderation of its growth rate, and Asian and ancillary economies dependent on China for a large part of their economic activity will also consequently slow.
At the same time, domestic non-farm economic activity, both manufacturing and services, remains strong and is backed by robust demand, which might increase if the monsoon rains coverage results in expectations of a good kharif harvest. Anecdotal evidence suggests that corporates have revived their capex plans and will soon begin to increase demand for credit. Inflationary pressures will gradually increase, even as the locus of price increases shifts from food to greater demand led ?core? inflation, particularly as excess capacities begin to shrink.
In other words, while domestic demand conditions warrant tightening, global uncertainty makes it prudent to extract the largest possible impact from the minimum possible rate increases. Our view based on all this? The likelihood of a 25-50 repo/reverse repo rate increase, as a signalling device, both of a tightening (via the repo rate) and of a more efficient transmission mechanism via the shorter end of the yield curve, through more stable money markets.
The author is senior vice-president, business and economic research, Axis Bank. These are his personal views