Monetary policy does pack a punch

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Published: Thursday, 06th December 2018

The fifth bi-monthly meeting of the MPC of the RBI in the current fiscal was billed to be a non-event since just about everyone was certain that the policy repo rate would be kept unchanged at 6.50%. It turned out to be not exactly a non-event although the MPC kept both the policy rate as also the stance unchanged. Quite a few significant developmental and regulatory policies measures were announced by RBI alongside the monetary policy, one of which was the decision to align the SLR with the LCR requirement of banks, which is currently at 18% of the net demand and time liabilities (NDTL). Beginning the first quarter of 2019, SLR will be cut by 25 basis points every calendar quarter until the SLR, which is now at 19.5% of NDTL reaches 18%. This measure will free up a significant amount of funds for lending purposes, and will strengthen the present rising trend in credit expansion by banks.

While both the kharif and rabi productions are likely to be low due to below-normal monsoon, the recent uptick in industrial activity in the third quarter, and the strong business conditions in the services sector which expanded in November at the quickest pace in four months indicate that the underlying growth momentum of the economy is not faltering and still strong.

The price of the benchmark 10-year G-Sec moved up after the policy announcement. 

Macroeconomic data released in the weeks following the last policy meeting in October, in which the MPC kept the policy rate unchanged, but changed the stance from ‘neutral’ to ‘tightening’, portrayed a somewhat downbeat picture for the growth and inflation prospects of the Indian economy. The growth rate for the second quarter of 2018-19 fell sharply to 7.1% from 8.2% recorded in the first quarter, while the CPI inflation reading for October at 3.3% was lower than the 3.9-4.5% range projected by RBI for the second half of 2018-19. The market expected that the RBI would lower both the growth and inflation projections for the remainder of the current fiscal year.   

As the statement released by the MPC indicates, going forward the growth prospects present a mixed picture. While both the kharif and rabi productions are likely to be low due to below-normal monsoon, the recent uptick in industrial activity in the third quarter, and the strong business conditions in the services sector which expanded in November at the quickest pace in four months indicate that the underlying growth momentum of the economy is not faltering and still strong. As per RBI’s Industrial Outlook Survey (IOS), the overall business sentiment in the third quarter remained stable, with sustained optimism about production and exports.

The facts behind the fall in CPI inflation in October are interesting, to say the least. While the core CPI inflation (CPI excluding food and fuel prices) rose, a deflation in food prices more than offset the increase in core inflation. Deflation in vegetables, pulses and sugar deepened in October. Inflation expectations of households in November fell by 40 basis points for the three-month ahead horizon, while they remained unchanged for the twelve-month ahead horizon. Producers’ assessment for input prices inflation eased marginally in the third quarter, while agricultural as well as industrial input costs remained high. Rural wage growth remained muted in the second quarter but staff cost growth in the manufacturing sector remained high.

Banks will no longer be able to price their floating rate loans (of the three types, to start with) on cost-plus basis, which will make intermediation more efficient and transmission of monetary policy more effective. However, the impact of this measure will reach its logical conclusion, only if banks are able to price their liabilities also on the basis of external benchmarks.

The MPC has kept unchanged the growth rate projection for 2018-19 at 7.4% (7.2-7.3 per cent in the second half of the fiscal) and 7.5% for the first half of 2019-20, with risks somewhat to the downside. Its projection for CPI inflation has been lowered to 2.7-3.2 per cent in H2:2018-19 and 3.8-4.2 per cent in H1:2019-20, with upside risks. These risks seem to be real, because any reversal in the sharp fall in food prices as well as in the oil prices can derail this projection. The MPC’s decision to keep the stance unchanged reflects this possibility. However, going forward, for the sake of providing more clarity and context in respect of the MPC’s decisions, assessment and projections need to be made separately for core CPI as well.     

Apart from the measure to reduce the SLR to be in alignment with the LCR, another regulatory measure announced today will have far-reaching consequences. This relates to the requirement that banks will henceforth be required to price their new floating rate personal loans, retail loans and floating rate loans to micro and small enterprises on the basis of any of the several prescribed external benchmarks. This means a paradigm shift in the way loans are priced, on the one hand, and asset-liability risks are managed, on the other, by banks. They will no longer be able to price their floating rate loans (of the three types, to start with) on cost-plus basis, which will make intermediation more efficient and transmission of monetary policy more effective. However, the impact of this measure will reach its logical conclusion, only if banks are able to price their liabilities also on the basis of external benchmarks. This will be a challenge. With the adoption of the new approach for pricing, banks’ balance sheets will be exposed to the interest risk associated with the external benchmarks they chose for this purpose. It will be easier, and perhaps cost-effective, to manage these risks if both OTC and exchange-traded interest rate derivatives with the external benchmarks as the underlying are introduced and made popular in India. The RBI will be required to make progress in this direction soon.  

Financial markets in India and elsewhere can be and are volatile at times. So, can be the views and opinions of market-watchers and analysts. According to a recent poll conducted by a premier news agency covering 70 economists, 60% of the 51 respondents who were also polled last October changed their forecasts from a ‘hike’ to a ‘no hike’ by MPC in the fifth bi-monthly meeting. This is encouraging provided the monetary policy setting by the MPC is increasingly seen as data-dependent. In that event, the odds are high that the markets will do the same. This issue is important because a section of the market analysts thinks that a ‘dovish’ stance now on the monetary policy would also be desirable in the light of the reported rift between the government and the RBI on a few issues, including the expansion of lending by the 11 PSU banks which are currently under the PCA of the RBI. One hopes that the MPC will continue to demonstrate through its deliberations and actions that nothing but following its mandate matters. Its performance has been confidence-inspiring in this regard. 

(Himadri Bhattacharya is a former central banker and consultant to the IMF)