By Rajeev Malik

A crucial reform with the potential of ushering in a favourable economic disruption is suffocating. I’m referring to the Flexible Inflation Targeting (IT) framework and the related monetary policy committee (MPC). These, along with the understandably high—even if overhyped—expectations from prime minister Narendra Modi, prompted optimistic views of a virtuous structural decline in retail inflation and interest rates, which, in turn, would boost India’s growth to scale new heights.

The reality, however, is far from that. The government hasn’t followed up with the relevant reforms in the real sector that would have facilitated more aggressive monetary easing, and the MPC’s functioning, guidance, and forecasting track record leave a lot to be desired. RBI, too, cannot be let off the hook. The upside is that not all is lost. While the bar to facilitate a long overdue structural fall in domestic interest rates is high, it isn’t out of reach.

Barring the impact of the recent temporary jump in food inflation, headline CPI inflation has been in sync with the MPC’s mandate of 4%, with a band of +/-2%. Indeed, even including the recent surge, headline inflation has averaged 3.8% in the MPC’s lifetime. However, this snapshot doesn’t reveal the complete story. First, the economy is in a prolonged subdued phase; this makes low inflation more likely because of soft aggregate demand pressures. To be sure, except for a short phase in 2018, when the policy repo rate was increased (2x25bps) because of the risk of elevated core inflation spilling over to headline inflation, the MPC has been in easing mode.

Second, the absence of a confidence-inspiring institutional framework for managing volatility in food prices has come back to haunt us. The Modi government deserves kudos for having judiciously managed key food prices in prior years; this action was critical in simplifying the MPC’s task. However, it was done in an ad-hoc manner, with no institutional certainty that future success is ensured. The approach failed this time.

Third, there is a structural component in India’s core inflation (it has averaged an elevated 4.8% since the MPC’s birth), such as in education and health sectors, because of chronic demand-supply mismatch in a supply-constrained economy with rising aspirations of people. There has been insufficient focus to ease these imbalances via lasting supply-side measures.

The MPC, too, has to pull up its socks. First, it needs to better explain its poor forecasting track record for both CPI inflation, and GDP growth. Second, the MPC (along with RBI) was late in acknowledging the severity of the fallout from the NBFC debacle on economic growth. Consequently, it was slow to ease, and did so gingerly as opposed to moving pre-emptively and aggressively.
Third, the consolidated—Centre plus states—fiscal deficit is hardly the critical focus it should be. What matters for monetary management is the consolidated fiscal position, but members are usually silent about it. Most members also appear timid about meaningfully raising fiscal-related concerns, including the use of asset sales as revenue instead of a financing item; this masks the true fiscal deficit. Frankly, the fiscal support to the economy is greater than what the official data suggest.

Finally, MPC’s actions have sometimes suggested that it doesn’t believe its own inflation forecast. Thus, it guided earlier this month that CPI inflation is forecast to decline to 3.2% in Q3FY21, with risks broadly balanced, from an upwardly revised 6.5% in Q4FY20. It is odd that, for a meeting held in early February, the MPC chose to be swayed by inflation in the next couple of months (“The path of inflation is, however, elevated and on a rising trajectory through Q4FY20.”) instead of the significant decline thereafter. Perhaps some members haven’t fully appreciated the choice of “flexible” in India’s IT.

Unfortunately, the Reserve Bank, too, isn’t without blame. First, Governor Shaktikanta Das has been releasing a separate Statement by Governor alongside the MPC’s resolution, and changes in development and regulatory policies. One struggles to understand the relevance of this addition. Recall that in the pre-MPC era, it was the Governor’s statement that included both monetary, and development and regulatory policies.

Second, the Statement by Governor would be less problematic if it were just a mundane summary of what has been announced separately. It mostly is, but there was a new qualitative flavour in the February statement. While referring to the MPC’s decision to keep the repo rate unchanged, the Governor declared triumphantly, “While this decision may be on expected lines and perhaps widely discounted, it is important not to discount RBI!” (don’t miss the choice of the exclamation mark). The Governor seemed to be playing up that RBI can take steps to lower interest rates even if the MPC stays on hold. RBI’s cloyingly sweet lollipop of long term repo operations (LTROs) was significantly more bullish than, say, a 25bps cut.

Unfortunately, the MPC seems to be undermined, perhaps inadvertently. To be sure, this wasn’t the first time RBI announced policy and/or regulatory changes, but one is hard-pressed to recall prior MPC chairpersons carving out such an unnecessary exultant distinction.

Third, RBI has revered the discipline in recent years of using the option of adjusting the cash reserve ratio (CRR) mainly in case of a crisis. It did so by exempting the CRR for incremental credit for automobiles, residential housing, and loans to micro, small and medium enterprises (MSMEs), in order to encourage bank lending to “productive” sectors (as if these are the only productive sectors). Let’s be sure: This option has been excercised not to deal with a crisis, but to limit the fallout from policy gaffes, and delayed and inadequate corrective response to reverse the prolonged downshift. It is a damage control excercise that sets up a dangerous precedent of a return to bureaucratic-style lending-related decisions without adequate accountability.

Fourth, the Reserve Bank, understandably, won’t admit that it is targeting the yield curve by using LTROs, but that is what is happening, even if improving monetary transmission is the officially stated goal. Given that RBI is also the debt manager of the government, the LTRO is a convenient tool that favourably distorts the shape of the yield curve, which was already affected by RBI’s version of “Operation Twist” in December. The Reserve Bank’s actions are distorting term premia and credit spreads, both of which were unfavourable for well-known underlying reasons, but also contained valuable price information for policymakers about the underlying distress.

The choice of LTROs shows that the Reserve Bank has learnt the wrong lessons from the European Central Bank (ECB), which had used this instrument during the Eurozone debt crisis. That region was in a worsening financial crisis while India isn’t embroiled in one. Also, unlike the uncomfortably low policy rates prevailing when the ECB launched the unconventional LTROs, India has significant room to cut policy rates. It is, of course, a different matter than the government’s poor food supply management—in sharp contrast to the exemplary response in recent years—stalled rate cuts by the MPC. However, in the new RBI script, the central bank has several tricks to push rates lower, even if the MPC doesn’t cut rates for the remainder of its term that ends later this year.

There is no clarity by RBI on what magnitude of monetary transmission would satisfy it, and thus, prevent additional measures. Consequently, investors have more variables to assess. Unfortunately, the MPC is becoming a sideshow as RBI reverts to a version of the old, discarded Governor-centric multiple-targets approach. Perhaps, it will next mimic the ECB’s Targeted LTROs and/or some form of subsidised lending to specific sectors. After all, RBI has become the proverbial fountain that keeps giving.

The writer is Founder & director, Macroshanti Pte Ltd. Views are personal