Expert View | Jahangir Aziz
The great normalization programme begins
Last October in Basle, governor D. Subbarao announced that Reserve Bank of India (RBI) would exit early from monetary easing. In the October policy review, RBI started the process by withdrawing the “unconventional” easing measures, including ending regulatory forbearance and the special financing facilities. By December, all the “unconventional” measures were eliminated barring a handful. In yesterday’s policy review, RBI turned to the conventional measures focusing first on returning excess liquidity to normal by raising the cash reserve ratio (CRR). Consistent with this tightening, RBI raised its growth and inflation projections and in a subsequent press conference clarified that its strategy was to normalize liquidity before moving to other instruments, hinting quite openly that a hike in rates was up next.
One can debate the tightening and RBI’s views on growth and inflation. But there is something to be said about this new approach of RBI: clarity and consistency. This is a good thing. There is a mistaken belief in India that for monetary policy to be effective it has to surprise. This view owes its genesis to a paper written by Bob Lucas way back in the late-1970s where he showed that only monetary surprises affect growth, anticipated changes do not. What is missed is its corollary: monetary changes always affect inflation. So to control inflation, monetary policy should be predictable. I am not talking about the efficiency of monetary policy in curbing inflation. The issue is about communication. The more transparent and clear monetary policy is, the easier it is to control inflation and any other nominal variable. So RBI needs to be congratulated for the increased clarity and transparency. And of course for brevity—the policy statement was just 10 pages!
The policy, I thought, was a tad dovish. A 100 basis points hike in CRR is perhaps needed to return liquidity to normal and not 75 basis points. So one can expect another 25 basis points increase in CRR in the April policy review and a 25 basis points increase in policy rates to bring the system to normal. But I am perhaps splitting hairs.
The economy has been turning hot for some time and core inflation has hardened sequentially. If the global recovery remains on track then 9-12 months ahead, growth in India will probably be running ahead of potential, exerting pressure on capacity and pushing up core inflation. Of course there are risks. On the downside, the global recovery might falter. But equally scary is the prospect of severe inflationary pressures in June. If that happened then RBI would be forced to move very aggressively from an easy stance. Moving quickly to normalize now is the safe strategy. From normal monetary conditions one can tighten if inflationary pressures emerge or ease if growth falters.
After last week’s tightening in China, monetary policy in two of the largest economies in world has now shifted decisively towards a return to neutrality, signalling the start of the Great Normalization.
Jahangir Aziz is India chief economist JPMorgan Chase The views expressed are personal.
Expert View | Tushar Poddar
Central bank risks falling behind the curve
The Reserve Bank of India (RBI) fell a tad short of the resoluteness required to begin the exit from a remarkably loose policy mix. We were expecting a 50 basis points hike in the cash reserve ratio (CRR), and 25 basis points on the reverse repo. Policy normalization requires not just managing liquidity but importantly—a normalization in policy rates. There is little justification for leaving the benchmark corridor untouched when inflation is so far ahead of where RBI wants it to be, and growth projections are consistently being revised upwards. Admittedly, there is inertia in policymaking—central bankers find it loathe to change course rapidly, and status quo tends to prevail for longer than it should. However, there are powerful reasons why rates needed to be raised.
First, given the long transmission lags between policy rates and activity, there is merit in starting withdrawal of accommodation early in the cycle. During the previous rate-cutting cycle, policy rates took a long time to feed through to bank deposit and lending rates, and that too only partially; similarly on the way up, bank rates may take considerable time to react, and from rates to activity will take further time. Policy needs to be forward-looking and cognizant of these lags.
Second is the importance of staying ahead of expectations. For market participants, the question was not if RBI needs to hike rates, but when, and if RBI waits till financial markets are imploring it to raise rates, it may fall behind the curve. Once dovish credentials are established, it will be difficult to shake them off.
Third, the yield curve is amongst the steepest it has ever been. Short term real interest rates are negative, and one of the lowest among emerging markets. The short end needs to move up to normalize policy, which mere liquidity withdrawal may not be able to achieve. Our own analysis suggests that it would require short rates to move up by 300 basis points in order to move rates to neutral.
Fourth, the independence of the central bank is in question. The constant stream of exhortations from the government not to hike rates has raised doubts about the central bank’s ability to take independent decisions.
Since September 2008, fiscal and monetary policy had come together in the face of an unprecedented financial crisis, but as normality returns, it is essential they go back to fulfilling their respective roles. Growth has many fathers, but inflation is an orphan. Everyone wants to associate themselves with high growth—it is popular and it is easy. For the tough decisions against the problem child of inflation, the monetary authorities are the best placed. The relative success of inflation-targeting regimes bears out that central banks operate unhindered when inflation is the only objective. At headline inflation numbers of 8.5% relative to a medium term target of 4-4.5%, a “crisis-level” of interest rates is hard to defend. A well-communicated, timely, and gradual increase in interest rates should be started at the earliest in order for RBI to not fall behind the curve.
Tushar Poddar is vice-president and chief economist, Goldman Sachs, India.
Expert View | Saumitra Chaudhuri
RBI moves towards a neutral stance
The argument and cross arguments about monetary “tightening” and “easing” often skip over the fact that there must logically be a middle ground—the “neutral” stance. In October 2008, and the months that followed, as the world reeled from the financial crisis, governments and central banks rushed to provide a cushion to break the fall of the economy. This was particularly true of Asian economies, which mercifully did not have the structural problems of piles of bad debt, over-leveraged households and companies and collapsing economic fundamentals. It was natural to expect that the Asian economies, India included, would be quick to recover—and that it did, even if the poor south-west monsoon did put a dampener on proceedings. The danger in 2008 and early 2009 was always that of doing too much. For, whatever was done would have to be rolled back in order to restore “normal” conditions. To that extent, the Indian policymaker may be justified in now looking back and concluding that it had successfully not overdone the prescription.
Why, the reader may ask, was there a danger of doing too much? If after all, it is always possible to roll things back in short order. The problem is with the withdrawal symptoms. People get hooked on to easy money and fiscal concessions. The richer they are, the more they get hooked. Look at all the wailing that has been going on for the past many months.
The arguments why RBI ought to leave the monetary stance unchanged; why government ought to leave the fiscal stimulus in place, aka lower excise and service tax rates unchanged. It is good that RBI has started to take away the comforter. Hopefully, government too will do the same.
Having said this, one should point out that last year, RBI had cut its policy and reserve rates so fast, that the operating part of the interest rate corridor, i.e. the overnight money market rate, the shortest end of the yield curve, fell from double-digit levels to 3% in a matter of weeks.
For argument’s sake let’s posit that a “neutral” monetary stance corresponds to 5% interest rate. With smooth transition, how long does it take to move from 3% to 5%? Quite some time, no? Even if we were to concede that this “neutral” rate is 4.25%—even then that is a 4x25 basis points increase, something that may be expected to take anything close to a year. But before that the excess liquidity has to be drained and CRR (cash reserve ratio) increased. That RBI did on Friday.
Now, why does RBI have to move to a “neutral” stance? Because, there is every reason to believe that the Indian economy will quickly move to an 8.0% to 9.0% growth trajectory. And when it does, inflationary pressures are likely to develop along the many seams of the economy.
We are, as RBI pertinently noted, a “supply constrained” economy. Monetary policy must be, at that time, in a position to act meaningfully—which it only can if it has come to a stance that is “normal”, i.e. the “neutral” stance.
Saumitra Chaudhuri is member, Planning Commission.
Expert View | Rejeev Malik
A handle-with-care monetary policy exit
As expected, the Reserve Bank of India (RBI) favoured hiking the cash reserve ratio (CRR) over policy rates, emphasizing the need to anchor inflationary expectations via reduction of excess liquidity. While being more than market expectations, the 75 basis points CRR hike is not as bad as it might first appear. Indeed, the outcome is still better than the following two combinations that could have been considered by RBI: (1) CRR: +50 basis points and then a surprise CRR hike of 25 basis points a month or so later; and (2) CRR: +50 basis points and policy rates: +25 basis points.
The latest policy statement is the shortest one from RBI, and I am ecstatic that it has recognized that “less is more” in effective communication. It emphasized that the recovery has yet to fully take hold, and expects inflation to moderate from July onwards. My sense is that while food inflation will come down, non-food inflation will be a bigger issue owing to higher global commodity prices and improving demand. Further, supply side bottlenecks also complicate inflation dynamics, but there is little RBI can do about them. Hopefully, the government will rise to the occasion, finally.
RBI has embarked on a handle-with-care monetary exit. As it stated in the policy review, it is shifting its stance from “managing the crisis” to “managing the recovery”. However, it understandably warned that even amid rising inflation, the recovery is yet to fully take hold, especially for investment spending. While inflation has become more important, RBI has not yet totally taken its eyes off growth.
The next step will likely be on policy rates. The need for additional CRR hikes, if any, will be influenced by the effect of capital inflows and loan growth on money market liquidity. It is quite likely that the overnight rate move up towards the upper end of the LAF (liquidity adjustment facility) interest rate corridor before easing in the new fiscal year as government spending picks up.
The policy details do not alter my expectation that the policy rate normalization cycle will commence from March/April onwards, after the Union Budget is announced on 26 February. Cumulatively, a 100-150 basis points increase in policy rates over the course of FY2011 is likely, but that won’t derail gross domestic product growth of around 8.0% for FY2011.
Analysts going into a positive overdrive by only looking at elevated industrial production data are missing the important aspects that the recovery is not broadly based, has been supported by policy stimulus, and that the improvement in credit and investment is still weak. Further, those expecting a policy rate hike today were missing the point that it is far more effective to shrink excess liquidity before pushing up borrowing costs.
A critical issue for lasting and effective inflation management is how quickly the supply constraints exaggerate the impact on inflation of improving demand dynamics. The government needs to work harder and faster to ease the supply bottlenecks, and also fix the politically motivated mess in agriculture sector. RBI does not have a magic wand for fixing the supply side problems.
Rajeev Malik is head of India and Asean economics at Macquarie Capital Securities, Singapore. The views expressed are personal.
Expert View | A Prasanna
CRR increase should be viewed as incomplete
The January policy review marked the second phase of the Reserve Bank of India’s (RBI) exit from its accommodative stance. The central bank still chose to forego a hike in policy rates and limited itself to a 75 basis points hike in the cash reserve ratio (CRR). While the policy statement can be characterized as hawkish at one level and the quantum of CRR hike came as a surprise, RBI has taken care to intersperse its comments on inflation with dovish observations on growth. Indeed, by not hiking the liquidity adjustment facility (LAF) rates, RBI has diluted the effect of its hawkish policy statement. Consider the facts. The central bank upped its growth estimate to 7.5% for FY10 and indicated that this will be a base case scenario for FY11. Bear in mind that RBI’s FY10 projection implies a 9.1% growth in non-farm gross domestic product, close to the average 9.4% seen during the FY03-FY08 period.
The central bank also raised its end-March inflation estimate to 8.5%, admitted to some signs of demand side pressures and highlighted a rise in inflation expectations of households. The central bank also flagged off the risk posed by capital inflows in excess of the absorptive capacity of the economy. Reacting to these developments, it is logical to have expected the central bank to hike LAF rates to signal its discomfort with rising inflation expectations. While it can be argued that the central bank did not hike them because it is worried about the “unbalanced” nature of recovery, that doesn’t answer the question of preference for CRR over rates. One could understand the decision to hike only CRR if RBI envisaged a quick transition to the upper end of the LAF corridor in order to tighten monetary policy.
However, in post-policy comments, the RBI governor appeared to rule out such a tactic when he suggested that liquidity will remain surplus in March even after advance tax outflows. In my estimate though, system liquidity is seen tipping into deficit mode in the second fortnight of March. Perhaps the central bank is trying to tighten by stealth, but such hypotheses are impossible to validate. Back in the real world, a likely explanation is that RBI is trying to sequence its exit steps and the evolution of inflation is forcing it to improvise. Further, modulating liquidity is a difficult task in the fiscal fourth quarter when government revenues as well as expenditure peak in seasonal terms.
The central bank has thus chosen a tougher route to unwind its accommodative stance. On the one hand, we see no let up in the pressure exerted on policymakers by rising inflation, which could be exacerbated by a likely fuel price hike and a rollback of indirect tax cuts over the next few weeks. On the other hand, the likely swing in overnight rates between reverse repurchase and repurchase rates in March could infuse uncertainty into the domestic markets and raise questions about RBI’s motives. As a result, we view today’s policy action as incomplete and expect a hike of 50 basis points each in the reverse repo and repo rates by April.
A. Prasanna is chief economist, ICICI Securities Primary Dealership Ltd.