Crafting cogent central bank monetary policy statements is more an art than a science. Still, effective monetary policy statements have some common features, including a clear rationale for the policy decision, and some evolving consistent guidance which offers hints about the likely response function. These policy statements are like an evolving tapestry and changes—typically incremental but rarely unimportant from markets’ perspective—act as a key guide for managing market expectations.
RBI, under Governor Raghuram Rajan, has undertaken several welcome steps in enhancing transparency and consistency of its policy framework and communication. However, the guidance part in its policy statements continues to be work in progress. The guidance in its recent policy statements has become more eclectic for the central bank which has moved to flexible inflation-targeting (FIT). Inadvertently perhaps, this contributes to increasing uncertainty about the anticipated policy response function.
The run-up to the latest bimonthly monetary policy meeting showed that the greatest disconnect about the operational aspect of the monetary framework is—surprisingly—between the bankers and the RBI. Frankly, anyone who understands India’s monetary framework since the repo rate became the single policy rate wouldn’t have expected a cut in the cash reserve ratio (CRR). Neither would they have expected actions which would move the overnight rate to be significantly lower towards the reverse repo rate (currently 6.5%) from being close to the repo rate (currently 7.5%).
The CRR cut was talked about mostly by bankers. It is possible that they were merely talking their book and perhaps confusing a wish with expectation. Whatever the motivation, the very fact that some bankers thought that these actions were likely underscores the missing links in their understanding of RBI’s framework.
The issue here isn’t with RBI; it rests with the bankers. The fact of the matter is that given the relatively comfortable liquidity backdrop, a CRR cut was unwarranted. Like any central bank, RBI has a good handle on overall liquidity management only when it keeps the system short.
Under such a template, it provides additional liquidity as it deems necessary rather than create a chronic excess which pushes the overnight rate significantly below the repo policy rate on a sustained basis.
Poor transmission of monetary policy decisions is nothing new. A lot has been said about Governor Rajan’s angst about the near-lack of transmission of the 50 bps cut in the repo rate. Frankly, the real issue isn’t that the Governor Rajan finally spoke on this but that it took him so long. Consider this: even the private sector bank most dependent on wholesale funding hasn’t cut its base rate despite wholesale sales having declined more than the policy repo rate!
Separately, there is hardly any discussion about the nature of guidance in the RBI’s recent policy statements; this seems to have become more open-ended. Strangely, the length of the all-important paragraph on guidance was more than twice as long in the latest policy meeting at which the RBI stayed on hold (widely expected) than in the two meetings in which unexpected out-of-policy rate cuts were announced.
Two aspects of the guidance paragraph should be improved upon, in my humble opinion. First, avoid making the guidance too open ended. The mention of specific sectors contributes to that. Given the uncertain timeline, even the RBI cannot meaningfully quantify the impact of many of the supply-side factors.
The objective may be to mention the need for different policy measures from the government. This is understandable. But by getting into specific mention in the guidance paragraph (versus, say, in post-meeting comments or elsewhere in the statement), it also raises questions about those, such as labour, which it has overlooked to mention explicitly. Is it an oversight or is it unimportant or does the RBI not expect anything?
What ultimately matters in an inflation targeting framework is the outlook for inflation. Improving supply-side factors can contribute toward creating favourable conditions for inflation. However, sector-specific mentions gives rise to a wider band for the likely policy response function as there is uncertainty about their timing and impact. They give the impression that the central bank is giving itself too much room; this in turn unnecessarily increases uncertainty.
The best example of the above is the assessment about the FY16 Budget in February. After indicating “high quality fiscal consolidation” as a prerequisite for further monetary easing, RBI unexpectedly eased inter-meeting in March. It offered a laboured assessment which worked overtime to extol the intentions in the Budget. Interestingly, market expectations of a rate cut soon after the budget had pushed out to April but RBI was apparently pumped up by the Budget. To be fair, there were several positive and creative steps in the FY16 Budget. But if “high quality fiscal consolidation” was one of them, then I am Santa Claus!
A more welcome and simpler example about guidance on supply-side factors could be: “The government should step up supply-side measures which facilitate and enhance growth acceleration while ensuring that the inflation outlook remains consistent with target.” It covers a wide range of what the government can do and retains the ultimate focus on inflation for which there is an explicit quantifiable forecast.
Second, please be consistent. The RBI mentioned poor transmission by banks as a contributing factor for staying on hold this week and as an input for deciding on further action. That is selective and inconsistent reasoning. How come poor transmission wasn’t a factor when Governor Rajan was raising the policy rate? Actually, some analysts had even offered poor transmission as a reason for more tightening for it to be effective.
Based on the most recent version of the RBI’s logic, it should have paused, hammered the banks into raising lending rates adequately and then decided on further tightening. As we know, that script did not play out despite the elevated concern about inflation. In the spirit of accountability, the RBI could enlighten us about its long overdue, selective and asymmetric outburst on the chronically poor monetary transmission.
The writer is senior economist at CLSA, Singapore. Views are personal