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Photo: Mint

A good debut by India’s new monetary policy committee

The broad confidence instilled by the MPC is reflected in the gains notched up by financial markets

It is cricket season and hence the governor of the Reserve Bank of India (RBI) too resorted to terminology from the sport to explain the monetary policy and regulatory decisions taken by the central bank on 9 October. Shaktikanta Das asked bond market participants to be competitive and not combative. He said that both the central bank and market participants had a shared responsibility to ensure financial stability and an orderly evolution of the yield curve. Separately, RBI announced that it would buy state government bonds this fiscal year as part of its open market operations (OMO). Going by the response, the governor seemed to be deploying two OMOs—open market and open-mouth-inspiring (CHK).

It was good to see the central bank use risk weights as a countercyclical policy tool. Last year, it had lowered risk weights on consumer loans. This time, it extended the move to mortgage loans by temporarily severing the link between their risk weight and the quantum of the loan, with a link only to loan-to-value being retained. This column had urged the active deployment of risk weights as a policy tool in a column written over a year ago (Some Macroprudential Policies to Help Kick-Start a Credit Boom, 12 August 2019).

Financial markets cheered the monetary policy decisions, including the soft policy guidance that rates would remain on hold well into the next fiscal year. That it did not lead to a rise in risk premia—which would have indicated a loss of credibility—would have reassured the monetary policy committee (MPC) that its judgement was correct. Stocks went up. Bond yields fell and the rupee strengthened against the US dollar.

This reflects growing confidence not only on the part of the governor, but also on the part of financial markets in Das. The enhanced policy credibility expands the policy room available to the central bank.

For the time being, concerns of fiscal dominance are overstated. For all the recommendations made by many commentators, including yours truly, the central bank has not yet committed to open-ended or limited monetization of government borrowing. It has not crossed that Rubicon. Further, concerns of its policy ignoring risks of overheating also seem exaggerated. On 30 September, RBI had released quarterly statistics on India’s external debt and its net international investment position. When India last experienced overheating conditions in 2013, one of the indicators that was flashing a warning sign was the ratio of short-term external debt to foreign exchange reserves, which, at 33.1%, was the highest in three decades. As of 30 June 2020, this ratio stood at 20.8%, down from 26.3% in 2019. India’s balance of payments and current account are in surplus. For many, the worry is the inflation rate.

The official rate, measured by the annual percentage change in the consumer price index, as of August 2020 was 6.7%. This is above the upper end of the range of 2-6% that the MPC is expected to achieve with its interest rate tool. On the same day that the panel decided on RBI’s key interest rate, the central bank released its quarterly surveys on the economy: inflation expectations of households, consumer confidence, industrial outlook, manufacturing outlook, etc. Households’ expectations of inflation and perceptions of it have barely changed in the last four months, though m they are sharply higher from their levels six months ago. Digging deeper into the surveys of recent years gives us some interesting insights.

I examined seven of them from 2014 to 2020, released around September or October each year. Only for 2017 and 2020 did I examine all the household inflation expectation surveys. The year 2017 followed demonetization and 2020 is the covid year. In general, the single-largest response is of an inflation expectation of 16% or higher, both in the 3- and 12-month categories. Perhaps, a bunch of respondents offer that same response to all surveys. RBI would do well to calculate and publish prominently a trimmed mean forecast. Two, there are usually two large clusters: one is around the 5-6% range and the other at an inflation rate of above 16%. Three, more often, there is a large intersection between perceptions of the currentinflation rate and the 3- and 12-month ahead forecasts. Four, inflation expectations came down sharply in 2017 thanks to vast liquidity being sucked out of the system. Like the US in the 80s, India lowered its inflation sharply through a massive monetary contraction. It is not worth it. Five, both the perceived inflation rate and inflation expectations rose sharply in 2020 because of temporary supply disruptions. They should ease as normalcy is restored.

This simple exercise suggests that there is little or no intersection of the household inflation expectations formation and the monetary policy regime. Two, inflation generation should matter only to the extent that it affects medium-term output and employment generation. For now, other indicators suggest that it does not matter as it did in 2011-13. Therefore, there is no need to turn inflation-targeting into a fetish. The new MPC and the central bank have done well and done good. They should be pleased.

V. Anantha Nageswaran is a member of the Economic Advisory Council to the Prime Minister. These are the author’s personal views.

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