It’s fairly certain that the Reserve Bank of India (RBI) will raise both its policy rates as well as banks’ cash reserve ratio (CRR)—the portion of deposits that commercial banks are required to keep with the central bank—against the backdrop of rising inflation and resurgent economic growth.
There are three possible scenarios.
First, RBI can raise the repo and reverse repo rates as well as CRR by 25 basis points (bps) each. One basis point is one-hundredth of a percentage point. The repo is the rate at which the central bank injects liquidity into the banking system and the reverse repo is the rate at which it drains liquidity.
Second, it can raise all three by 50 bps each.
And finally, it can raise the rates by 50 bps, but CRR by half as much, as it would need to raise the rates, but at the same time ensure that the government’s hefty borrowing programme goes through smoothly. If liquidity is tightened too much, the government’s cost of borrowing will rise. I would think this will be the most likely action RBI will take on Tuesday when it announces its monetary policy.
Ideally it should raise all three by 50 bps each, but RBI would probably not like to be seen as the party pooper at this point and may prefer to wait and watch the monsoon’s progress and inflation. But it will not be easy to tighten policy further in July at its quarterly policy review as many believe that the inflation rate, which touched 9.9% in March, has almost peaked.
After raising banks’ CRR by 75 bps in January, RBI could not wait until April for its annual policy review and had to raise rates a month ahead of it to fight inflation. One can’t rule out a similar action in June, ahead of its first quarterly review. The best way such a situation can be avoided is by shifting to a monthly or even six-weekly review of monetary policy. A dynamic and globalized economy needs more frequent policy reviews.
Until 2005, the Indian central bank used to make two formal policy statements—in April and October—known as the slack season and busy season policies. Traditionally, May to September is the slack season when crops are sown and agriculture and allied activities are muted. In the absence of demand for credit from the commercial sector, the government borrows heavily in this season to bridge its fiscal deficit.
The busy season commences in October; both agricultural output and industrial production rise, pushing up demand for money.
With the change in crop patterns and industrial activities, former RBI governor Y.V. Reddy introduced quarterly reviews of monetary policy in fiscal 2006. He also constituted a technical advisory committee on monetary policy to advise the central bank.
Globally, most central banks conduct a monthly policy review and a few of them, including the US Federal Reserve, six-weekly ones. The Federal Open Market Committee, the policymaking body of the Fed, holds eight meetings every year at intervals of five to eight weeks and the minutes of such meetings are released three weeks after the date of the policy review.
Bank of England’s Monetary Policy Committee (MPC) meets every month to set interest rates. Throughout the month, MPC receives extensive briefings on the economy from Bank of England staff. This includes a half-day meeting—known as the pre-MPC meeting—that usually takes place on the Friday before MPC’s interest rate setting meeting. The monthly MPC meeting is always a two-day affair and the interest rate decision is announced at 12 noon on the second day.
The European Central Bank, whose primary objective is to maintain price stability, too makes its rate decision once a month even though its governing council meets twice every month. At its first meeting, the council assesses the economic situation and the stance of monetary policy and decides on the key interest rates while the second meeting focuses on other issues.
Among others, both the Australian central bank as well as the Bank of Japan make monthly announcements on rates. The board of Reserve Bank of Australia, which sets the target cash rate, the market interest rate on overnight funds, issues a release after each meeting explaining the rationale behind any rate action. The board usually meets on the first Tuesday of the month, except in January. The Bank of Japan, in contrast, does not have any set time for making such announcements.
Why can’t RBI shift to a monthly policy regime? The primary reason behind this is the lack of adequate data to track economic activity. Three key sets of data, which RBI does not have access to are retail sales, inventories of manufacturing firms and employment. Its assessment of the economic scenario is based on data related to inflation (both retail and wholesale), exports, imports and industrial production. All these figures are released monthly while data on the gross domestic product (GDP) are released every quarter. There are other monthly data such as sales of automobiles, cement despatches and airline passenger traffic. Besides, RBI has its own data base on the level of business confidence, household sector’s inflation expectations and growth in GDP.
Unlike in the US, it is difficult to compile reliable jobs data in India because a majority of the workers are employed in the unorganized sector. Similarly, no data is available on mortgages and one can only get a sense of construction activity from monthly cement despatches. Despite these limitations, the Indian central bank should increase the frequency of policy reviews if it wants to avoid the embarrassment and not-so-pleasant surprise of inter-meeting policy announcements. Along with this, it should also make public the deliberations of the monetary policy committee meetings even though it is advisory in nature.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Comment at firstname.lastname@example.org