An Eventful Year For Monetary Policy: In RBI’s Michael Patra’s Words
RBI executive director Michael Patra speaks on an eventful year for monetary policy
The October review by the Monetary Policy Committee (MPC) marked a year since India moved away from a framework driven by the Reserve Bank of India to one driven by a six-member panel. The first meeting of the MPC took place in September 2016 under Governor Urjit Patel. Since then, over a one-year cycle, the MPC has had to deal with unforeseen global and domestic changes, which have impacted the conduct of monetary policy. It has also moved from speaking in a single voice in its early meeting to reflecting very divergent views among the committee members.
Michael Patra, executive director in-charge of monetary policy and member of MPC, in an Oct. 27 speech detailed the pulls and pressures faced by the committee in its first year. The speech was uploaded on the RBI’s website. The excerpts from the speech below are in reproduced in Michael Patra’s words. The entire speech has not been reproduced.
The MPC’s First Meeting
As the MPC set about its first meeting, the accommodative cycle of monetary policy in India that commenced in January 2015 was maturing, with the policy rate having been reduced by a cumulative 150 basis points already.
Yet, the ground underneath was moving. Macroeconomic and liquidity conditions were about to undergo tectonic shifts.
The combination of a stronger than usual seasonal spike in vegetable prices, highly elevated pulses prices and international crude prices firming up from a recent trough, veered inflation up from its projected path during April-July 2016, even as growth slowed. In the August CPI reading – which was the first print that became available to the MPC – a glimpse of the forming vortex was revealed.
With a suddenness that overturned the April-July surge, inflation fell off a cliff as the prices of vegetables and pulses sank into deflation!
In these challenging circumstances, the MPC prognosticated inflation developments as “…a downward shift in the momentum of food inflation – which holds the key to future inflation outcomes….”
This assessment would turn out to be prophetic! On the hope that the satisfactory monsoon and cautious business optimism would quicken growth in the window of opportunity that the lull in inflation opened up, the MPC voted unanimously for a reduction of 25 basis points in the policy rate. This took the cumulative rate reduction to 175 basis points in this phase of easing. In this meeting, the MPC maintained an accommodative policy stance.
Demonetisation & Monetary Policy
Just a month later, demonetisation – which involved withdrawal of about 87 per cent of the outstanding stock of currency from circulation, setting off a sudden liquidity explosion in the system – altered monetary conditions drastically.
Over the next few months, the pangs of currency exchange preoccupied the nation, but when the definitive history of that time is documented, the RBI’s valiant defence of financial stability, right from the morning after, will hopefully receive its due. As the withdrawn currency notes were returned by the public, deposits flooded into banks and swamped them with idle reserves. A wall of liquidity started moving through financial markets, threatening to take down everything in its path – interest rates; yields; exchange rates; asset prices.
Standing alone between the ocean of liquidity and financial chaos, the RBI mounted an extraordinary liquidity absorption strategy.
It combined unconventional instruments with regular operations when the liquidity tsunami was so overwhelming that it could have completely depleted the RBI’s stock of government securities that are used as collateral in reverse repo auctions. In order to tide over the delay in obtaining market stabilisation scheme securities from the government, the incremental cash reserve ratio (ICRR) was deployed and for the first time in the RBI’s history, an ICRR of the size of 100 per cent of the relevant demand and time liabilities of banks was applied.
Defending The Inflation Forecasts
Three features distinguish these meetings of the MPC. First, it was assailed by the criticism of large one-sided inflation forecast errors right up to the June inflation print, which turned out to be a historic low. Demonetisation was readily available to denounce. Yet, the collapse in inflation occurred from August 2016, well before demonetisation, which could have accentuated it transitorily during November 2016-January 2017.
The cumulative deviation of 80 basis points between actual inflation and forecasts between August 2016 and June 2017 was entirely due to the twin deflation of vegetable and pulses prices that produced a trend shift, holding a mirror to serious errors in food management which would later ignite wide-spread farmers’ unrest.
In this context, the MPR of October 2017 stated:
“These developments may warrant a reappraisal of the scope and quality of food management strategies that seem prone to failure in the face of shocks in either direction. In the past too, supply shocks, of which large one-sided deviations of inflation from projections are merely a symptom, drove disinflation episodes.”
In the rush to pillory the scapegoat, attention was diverted from the real issues and consequently, from the right fixes. Second, there was an overwhelming preference to wait out the transitory effects of demonetisation. Although today, it appears the logical decision to take, markets were taken by surprise by the neutral stance and sentiment turned bearish.
At the cost of a hawkish tone, the MPC was striving to anchor expectations in a situation when even the near-term was a step in the dark.
The October Policy
The monetary policy statement of October 2017 was framed in quite a dramatic setting. Even as growth broadened globally, it slowed below 6 per cent for the second quarter in a row in India in April-June. At this rate, India was still among the fastest growing large economies of the world, but the blow from the growth print was significant enough to set off a chorus of alarm.
The slowdown was essentially located in manufacturing activity which slumped to a 20-quarter low. Over the recent few years, industrial output has shown synchronicity across geographies, with trade being identified as the channel of co-movement. In the early part of 2017-18, however, Indian industry has been an outlier, decelerating just when industrial production the world over is on the mend. Transient disruptions associated with the GST rollout are likely operating as a drag. Nonetheless, it is fair to say that the nation is impatient to see a revival in industry, especially as capital formation staged a modest recovery.
Sharpening the dilemma for the MPC, retail inflation rose nearly 200 basis points since its last meeting. The upturn was broad-based, provoking households to expect that the general level of prices would increase by more than the current rate in the months ahead. Input costs facing both farms and firms rose, but weak pricing power in conditions of subdued demand prevented a fuller-blown pass-through into retail inflation.
In the MPC’s assessment, inflation will likely rise from current levels in the rest of the year, with farm loan waivers and the implementations of pay and allowance revisions by states a la the centre posing upside risks. The MPC also pensively expressed concern about the spectres of geopolitical tensions and imminent normalisation of systemic central bank balance sheets that loomed over the outlook. On food inflation, the MPC’s prognosis was more sanguine though, with adequate foodstocks and supply management efforts seen as mitigating factors.
On growth, the MPC regarded the first estimates of kharif production – which were lower than last year’s level and the target for this year – and the GST rollout as early but transitory setbacks. It believed that agricultural activity will improve from here on. Furthermore, it found business optimism expressed by firms about prospects for the October-December quarter reassuring. Relative to its August assessment, the MPC lowered its growth forecast by 60 basis points which, in a rough and ready sense, measures the net lagged impact of shocks such as demonetisation and the GST.
The MPC expressed the view that recent structural reforms would support growth over the medium-term. Accordingly, it expected upsides to the growth forecast from the resolution of GST-related impediments and from the pay and allowance revision for state government employees, while the hardening of input costs and the loss of consumer confidence would balance the risks.
The MPC was particularly candid in drawing out the bottom line: “…it is imperative to reinvigorate investment activity.” For this, creation of a conducive environment for investment is critical, involving adequate recapitalisation of stressed banks, closing the infrastructure gap, simplifying the GST, hastening clearances and rationalising procedures by states relating to investment proposals.
Against this backdrop of its appraisal of the evolution of macroeconomic and financial conditions, the MPC decided to hold the policy rate unchanged and to maintain a neutral policy stance. In the reactions that followed, there seemed a central tendency that the MPC may have called right.