Two catalysts to dictate RBI's policy direction

There is near-unanimity that the Reserve Bank of India (RBI) will not cut rates during its monetary policy review on 4 August. Notwithstanding renewed softness in crude oil prices, pipeline risks are notable, specifically uncertainties over monsoon rains, direction of commodity prices, reform measures and external developments.

Two factors will shape India’s policy direction over the next 12 months. Externally, it will be the US Federal Reserve’s rate bias. Internally, India will need to finalize the shape and form of the RBI monetary policy committee (MPC). This is important because the new inflation targets are about to kick in officially.

On the first, US Fed chair Janet Yellen recently reiterated her optimism to start normalizing rates later this year, contingent on growth improving from a sluggish first quarter and a pickup in inflation. When US rates lift off, which we see taking place in the fourth quarter, RBI would have less room to narrow rates significantly.

Unlike the US rate hike cycle in 2004-05, India’s rates are unlikely to mirror rising US rates this time around to preserve interest rate differentials. Due to a prolonged period of near-0% US rates since the 2008 global financial crisis, and persistent inflation keeping Indian rates high, rate differentials are still near their record wide levels.

While these favourable and positive differentials give RBI room to keep rates on hold, heightened volatility in the global markets amid a rising US rate environment will make it difficult for RBI to lower rates. In fact, India will need to rely more on foreign portfolio inflows to uphold sentiment when rate differentials start to narrow modestly.

Secondly, the next crucial step is to strengthen, and not weaken, RBI’s inflation-targeting framework.

The formation of an MPC should ideally be finalized next year, in time for the new inflation targets to kick in. The nominal Consumer Price Index (CPI)-based inflation target of a 2% +/- band around 4% was approved earlier this year, at the behest of the central bank-appointed Urjit Patel Committee’s recommendations.

Under the new monetary policy framework agreement, MPC will be primarily responsible for policy decisions. This will be a departure from the current practice where the RBI governor consults an advisory committee, but is not bound by their suggestions, before making his decision. While all counterparties agree on the need for a committee, its composition has become a point of contention. This debate resurfaced after the government recently released a draft of the Indian Financial Code, which recommends that government-appointed members should be in a majority in MPC. A provision that the RBI governor could veto the final policy decision, in exceptional circumstances, has also been removed.

These recommendations are still in consultative stage. If adopted, these changes could dilute RBI’s powers and effectiveness in policymaking. Government’s active role in such a committee might undermine the central bank’s independence, especially if it results in a conflict of interests over broader economic priorities. Moreover, making RBI accountable to meet inflation targets without the requisite powers in policy decisions is inherently contradictory.

It is thereby prudent for the central bank to have a bigger say in policy decisions to maintain the credibility of the inflation-targeting process. In other inflation-targeting regimes globally, central bank officials make up the majority in such committees, with few external members and minimal government participation. In Thailand, for instance, the finance ministry carries an observer status, but does not vote.

Admittedly, these recommendations are still proposals that have not been cast in stone. It remains to be seen if the above downside risks are sufficient to deter the government from retaining a majority in the policy committee. Eventually, the preference remains for RBI to have the bigger and final say.

This is the first in a series of three articles by economists ahead of RBI’s monetary policy review on 4 August.