Decoding the direction of monetary policy
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Last week, Reserve Bank of India governor Urjit Patel, in an interview to Network 18, once again explained the rationale behind the change in policy stance of the monetary policy committee (MPC). On 8 February, the rate-setting committee changed the policy stance from accommodative to neutral in order to give itself more flexibility. The change surprised the market and many analysts interpreted this as an end to rate-cut possibilities in the current cycle. Consequently, bond yields shot up as the market was expecting the MPC to cut policy rates by 25 basis points (one basis point is 0.01 percentage point).
The policy statement clearly explained the reasons for changing the stance; this was also reiterated by Patel in the interview. For instance, lower headline inflation in recent months has been largely driven by a fall in food prices—which may rebound as the supply of cash improves in the economy. It is possible that food prices, particularly those of vegetables, fell because of a cash crunch in the aftermath of the government’s currency-swap initiative. Core inflation continues to remain sticky at about 5%. Global commodity prices have firmed up in recent months and the volatility in the foreign exchange market can also put upside pressure on inflation. The central bank expects inflation to remain in the range of 4-4.5% in the first half and 4.5-5% in the second half of the next financial year.
While the policy stance of the committee surprised many analysts, the sharp reaction of the market is equally surprising—it was, in any case, expecting a long pause after a 25-basis point cut. It is also likely that since the lending rates have come down significantly because of the currency swap, a rate cut at this stage would not have made much difference.
In terms of policy direction, there are at least two important points worth noting. First, a change in stance from accommodative to neutral does not necessarily mean that rates cannot be reduced from the present level. If inflation continues to undershoot the target, the committee may decide to cut rates at a later date. Differently put, it is difficult to argue that policy rates can only go up from the present levels. Second, the committee is now aiming to reach a position where it is able to maintain inflation close to 4%, which should be seen as a big positive for the economy.
After the rates were reduced in October, some market participants were of the view that perhaps the committee would be comfortable with inflation readings closer to the upper end of the given band. But that is not the case. The minutes of the December meeting, for instance, showed that in Patel’s view, “securing 4% (inflation target)—the central point of the notified target range—remains the primary objective”. If the committee is able to maintain inflation at about 4% on a durable basis, it will enhance macroeconomic stability in a big way and boost growth prospects. It will also open up space for a significant cut in policy rates. As Patel, in the above-mentioned interview, also explained: “The best way that a central bank can support growth on a durable basis is to ensure that the inflation is low, stable…. Very few countries grow at a high rate, if inflation is high and volatile. I think, in a way, we are doing our bit to support a higher growth rate but on a durable basis.”
Along with implications for economic stability and growth, it is also important for the rate-setting committee to maintain inflation closer to the target as it will cement its credibility. This will also help in dealing with short-run supply shocks. A recent working paper put out by the International Monetary Fund, Inflation-Forecast Targeting For India: An Outline Of The Analytical Framework, noted in this context: “As the FIT (flexible-inflation-targeting) regime gains credibility, and wins the public confidence in its ability to ensure price stability even in an economy subject to price level shocks, inflation expectations would remain aligned to the medium-term target, which in itself would ensure that the effects of supply shocks on inflation remain transitory.”
Therefore, the change in policy stance by the MPC should be seen from the broader perspective of its objective. To be sure, maintaining inflation close to the 4% level may not be easy for the committee due to the underlying complications of the economy. But keeping inflation close to the 4% target will not only help growth in the medium to long run, but will also build a strong track record for the committee which will have a bearing on its actions in the future.
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