Clarity emerges on monetary policy stance

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Published: Friday, 07th December 2018

The penultimate monetary policy for fiscal 2018-19 has maintained status quo on the policy repo rate at 6.5 per cent but what stands out is the clarity with which the MPC resolution and the RBI leadership has spoken this time on critical areas like liquidity, volatility in retail inflation, growth outlook and the usage of monetary policy instruments.

The moot question is when the retail inflation outlook looks so benign and is below the average inflation target of 4 per cent as given in the legislative mandate to the MPC, why has the policy rate not changed? And more importantly, why has the monetary policy stance also not changed from “calibrated tightening” to “neutral”, as indeed, one of the MPC members had suggested?

The MPC resolution has set out a lower retail inflation outlook (2.7 per cent – 3.2 per cent in H2 of 2018-19 and 3.8- 4.2 per cent in H1 of 2019-20) measured in terms of Consumer Price Index (CPI). However, the growth outlook has been kept at 7.4 per cent for 2018 -19 and 7.5 per cent in H1 of 2019-20.

The moot question is when the retail inflation outlook looks so benign and is below the average inflation target of 4 per cent as given in the legislative mandate to the MPC, why has the policy rate not changed? And more importantly, why has the monetary policy stance also not changed from “calibrated tightening” to “neutral”, as indeed, one of the MPC members had suggested? The critical factor is not the lower level of food and fuel inflation but the volatility associated with food and fuel prices. There is a possibility of a “sudden reversal” as the “prices of several food items are at unusually low levels”. Besides, there are uncertainties on the inflationary impact of minimum support price and also on the medium-term outlook of the crude oil prices.

More importantly, inflation management is more about anchoring of inflation expectations. To this extent, the household inflation expectation survey by the RBI in medium term perspective has remained on a higher trajectory. Last but not the least is the most crucial factor – the fiscal slippage both at the Centre and at the States in what is an important election season will impact the inflation outlook, heighten market volatility and crowd out private investment.

Core inflation (headline number adjusted after removing sensitive items like food and fuel) has remained sticky and also at a higher level. More importantly, the output gap according to the MPC resolution is virtually closed, implying that the economy is operating at its potential level.

There is a clear distinction between durable liquidity and frictional liquidity and the RBI has used Open Market Operation (OMO) purchases for addressing durable liquidity to the extent of Rs. 360 billion and Rs. 500 billion in October and November 2018 respectively. It will further take recourse to Rs. 400 billion OMO in December 2018.

In view of the foregoing, the MPC has taken a matured and well-calibrated decision to keep the policy repo rate rate unchanged. According to the MPC, “the benign outlook for headline inflation is driven mainly by the unexpected softening of food inflation and collapse of oil prices in a relatively short period of time.”

Another important macro-economic and financial market issue is liquidity management. When the MPC resolution is seen in conjunction with the Governor Dr. Urjit Patel, and Deputy Governor Dr. Viral Acharya’s statements, a few important points emerge.

First, there is a clear distinction between durable liquidity and frictional liquidity and the RBI has used Open Market Operation (OMO) purchases for addressing durable liquidity to the extent of Rs. 360 billion and Rs. 500 billion in October and November 2018 respectively. It will further take recourse to Rs. 400 billion OMO in December 2018. To meet the frictional liquidity challenges, the RBI has taken recourse to term repo of various maturities on a daily basis and the amount aggregated to Rs1.471 trillion in October, November and up to December 4, 2018. Second, the RBI has said it is committed to transparent and market related instruments like OMO and term repos where the interest rate is market determined in contrast to the Cash Reserve Ratio (CRR), which is a non-market monetary policy instrument. Third, as clarified by the Governor, changes in CRR are not under the purview of MPC. This is an important clarification for market participants. In this context, it is important to mention that for the benefit of the banks and market participants, the RBI has decided to publish the CRR balances on a daily basis with a lag of one day, as is the case with the money market rates.

How will the Indian economy will break from the seven plus per cent potential growth to a higher level?  How will the retail inflation rate be maintained at the mandated level of average four per cent and what are the downside risks to interest rate scenario with a frequent OMO purchases?

It is recognised that bank credit flows to various sectors in the economy, particularly to industry and agriculture is an important element of evaluating whether transmission of the monetary policy stance is in the right direction. It is heartening to note that, as the Governor mentioned, the latest non-food credit growth at 15.3 per cent is higher than the current nominal GDP growth rate. This development is critical as credit flow oils the wheels of economic growth. Furthermore, as announced in the statement on Development and Regulatory Policies, it has been decided by the RBI to align the Statutory Liquidity Ratio (SLR) and Liquidity Coverage Ratio (LCR) by reducing SLR by 25 basis points every calendar quarter until it reaches 18 per cent of Net Demand and Time Liabilities (NDTL) from the current level of 19.5 per cent, such reduction in SLR will help banks to increase credit flows to the economy.

There a few critical questions. How will the Indian economy break from the seven plus per cent potential growth to a higher level?  How will the retail inflation rate be maintained at the mandated level of average four per cent and what are the downside risks to interest rate scenario with a frequent OMO purchases?

Economic growth is a function of investment limited by savings. To move to a higher growth rate, the financial savings rate needs to move to a higher trajectory with a durable full stop to government dis-savings. While fuel price volatility is largely exogenous, food inflation management and service inflation management is critical and is for the RBI and the government to manage. OMO purchase and debt management needs to be coordinated in terms of timing and volume of government borrowing and OMO.  At the same time, we need prudent management of fiscal policy not only in terms of lower fiscal deficit but also with zero revenue deficit and zero fiscal slippage.

(Pattnaik is a former central banker and faculty member at SPJIMR)