Photo: Bloomberg
Photo: Bloomberg

RBI monetary policy: Lost in transmission

RBI needs to be mindful of how liquidity conditions lubricate policy transmission in a systematic manner

After the pre-emptive and out-of-turn policy rate cut in March, the Reserve Bank of India (RBI) pressed the pause button in the first bimonthly review of monetary policy for the current fiscal year, with the outcome being widely anticipated by the markets.

While faster-than-anticipated easing in retail inflation prompted the first round of rate cuts, totalling half a percentage point in the fiscal fourth quarter, incremental monetary easing is gradually getting tied to a pickup in monetary transmission, legislative and administrative progress in easing of supply constraints, and global developments. All these factors are likely to play out in favour of incremental monetary easing to the extent of 25-50 basis points (bps) by September. A basis point is one-hundredth of a percentage point.


RBI projects retail inflation at 5.8% for March 2016. Since the central bank adopted flexible inflation-targeting, consumer price inflation has remained consistently below its target since June last year. It’s comforting to know that the central bank anticipates retail inflation to consistently remain below its 6% target for January 2016 through 2015-16.

While RBI expects risks surrounding its retail inflation estimate to be fairly balanced, we see risks skewed to the downside. With the expectation of a normal monsoon, restrained adjustments in minimum support prices, benign global commodity price outlook, and ongoing quality fiscal adjustments, we expect retail inflation to undershoot the target by as much as 60 bps.

Legislative and administrative progress

In the budget session of Parliament, the government was able to push through three important bills related to insurance, mining and coal. In addition, the government also approved the utilization of stranded gas-based generation capacity, issued a draft framework for revival of micro, small and medium enterprises, while also unveiling the much awaited foreign trade policy for 2015-20. During the course of the year, activity on land, labour, power and infrastructure is expected to gradually gain momentum.

Global developments

From a global perspective, two important developments will be worth watching—commodity prices and normalization of US monetary policy. Amid the backdrop of a supply glut and weak demand conditions, commodity prices are expected to stay soft. While the commencement of the monetary policy normalization in the US is inevitable, the Federal Reserve is likely to be conservative with respect to the timing and pace of interest rate hikes in order to avoid jeopardizing the slow pace economic recovery in an environment of global disinflation.

Monetary transmission

While RBI has in the past linked future rate actions to inflation and government policy actions, it is interesting to note the inclusion of monetary transmission to this list. Despite the cumulative 50 bps reduction in the repo rate in the three months ended 31 March, monetary policy transmission has not trickled down to borrowing and lending rates in the banking system.

Tight seasonal liquidity, especially in March, had impeded the transmission of past monetary actions. However, RBI successfully demonstrated active liquidity management towards the end of the year with volatility in short-term money market rates being much lower relative to history. In fact, rates for three-month borrowing instruments such as government securities and certificates of deposit have dropped by 48 and 73 bps, respectively, since their peaks in March.

A pick-up in government expenditure at the beginning of the financial year and tactical cancellation of RBI’s forward contracts ($11.4 billion is up for maturity by end-May) will infuse enough liquidity to reduce the overall deficit to almost half of its end 2014-15 level of 1.11 trillion. This is likely to kick-start monetary policy transmission over the course of the next few weeks.

Moving beyond the seasonal variations in liquidity, RBI needs to be mindful of how liquidity conditions lubricate policy transmission in a systematic manner. While term money market and variable rate overnight repo auctions are addressing the availability of liquidity in a successful manner (and guiding the market rates closer to the policy rate), it is imperative for the banking system to derive this comfort in advance. Moreover, the information asymmetry on assessment of short-term liquidity outlook between RBI and the banking system needs to be bridged. The auction of government cash balances with RBI along with high-frequency disclosures on drivers of liquidity will help in bridging this asymmetry gap, thereby playing a crucial role in future policy transmission.

Shubhada Rao is chief economist at Yes Bank Ltd.