The Reserve Bank of India’s (RBI) newly constituted Monetary Policy Committee (MPC) will deliberate and decide on the policy repo rate, currently at 6.5%, to keep CPI inflation within a target zone of 2-6%.
CPI inflation in August 2016 came down to 5% year on year in August 2016 after touching 6% in the preceding month. The recent decline in the rate of inflation has solely been on account of a better agricultural outcome because of the normal monsoon rains over the past few months, rather than high policy interest rates.
India’s new MPC can be expected to vote in line with the RBI Governor. All MPC members will be presented with the data and view of the RBI staff, as in the case of other countries MPC.
The RBI’s monetary policy statement of April 2016 indicates that it will also be targeting its balance sheet size or reserve money (net foreign assets plus net domestic assets that comprise lending to the government and commercial banks).
As can be seen from the chart below on reserve money growth, the contribution of RBI’s credit to the government has risen sharply compared to the increase in net foreign assets (NFA) in recent months. Previous rate cuts have failed to translate into lower borrowing costs, and the policy focus announced in April is meant to address liquidity needs in the economy. This could potentially be inflationary in the months ahead.
Thus , the RBI is presently deciding on three things – i) the policy rate ii) reserve money and iii) the foreign exchange rate via intervention in the foreign exchange (FX) market.
The key question going forward therefore is - what exactly will the MPC be deciding on to meet its inflation target? If it is only the policy rate, then the scope of the MPC would be limited as inflation is also impacted by RBI’s decision on reserve money as well as the FX rate through intervention.
If the MPC has no control over RBI’s target of its balance sheet, and of its target foreign exchange rate (the RBI has been regularly intervening in the foreign exchange market), it is very difficult to fathom how the MPC will be able to deliver on its mandate successfully. A focus solely on the repo rate would imply that the MPC would have no say in real policy.
Additionally, it is presently difficult to discern the rate of economic growth because of conflicting data. While the GDP growth rate is estimated at over 7%, other data including index of industrial production (IIP), bank credit growth (see chart below) and non-oil non-gold import growth would imply a lower GDP growth rate.
A manufacturing real growth rate of 9.1% in GDP estimates for the quarter ended June 2016 is at complete odds with a decline in manufacturing output of 0.7% y-o-y in the index of industrial production and a nominal credit growth to industry averaging less than 1% in the same period. The MPC members have to determine what numbers to rely on as an estimate of activity to decide on monetary policy.
While setting policy rates, one hopes that the MPC would also debate the role of interest rates on other aspects of the economy such as in higher domestic rates encouraging capital inflows given globally low/negative yields that may be putting pressure on the rupee to appreciate and moving it away from its more fundamental . The overd currency may impose significant costs on growth via imports of cheaper goods leading to a potential hollowing out of industry.
The newly constituted MPC provides an opportunity for greater transparency to communicate what variables it will decide on – policy rates, reserve money growth and exchange rate targets. Similarly, there should be greater transparency on what is the gauge of economic activity being used to set monetary policy. In the current situation do the members give more credence to GDP numbers or other numbers such as IIP, bank credit growth, non-oil imports, etc?
The communication of the deliberations, view and decision of the committee and its individual members would lend greater transparency to the basis for setting the monetary policy rate and would be invaluable information to the general public.
Rajan Govil is Managing Director at Marketnomix and a former International Monetary Fund economist. He has also worked as an investment strategist in the private financial sector.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.
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