Neutral Stance Allows RBI Flexibility To Move In Either Direction: MPC Minutes

The decision to change the monetary policy stance from ‘accommodative’ to ‘neutral’, which took markets by surprise on February 8, is intended to allow the Reserve Bank of India (RBI) greater flexibility in moving on interest rates in either direction, showed minutes of the Monetary Policy Committee meet released on Wednesday.

All six members supported the decision to keep the policy rate unchanged at 6.25 percent. Four of them gave views supporting the change in stance while the statements from the other two (Chetan Ghate and Pami Dua) made no reference to the decision to move to a neutral stance.

The six member MPC consists of three RBI members - Governor Urjit Patel, Deputy Governor Viral Acharya and Executive Director Michael Patra. Ravindra Dholakia, Chetan Ghate and Pami Dua are the three external members.

In Support Of A Neutral Stance

In his statement, RBI Governor Urjit Patel said that transient factors have “discoloured” an objective assessment of inflation pressures. The governor was of the view that vegetable prices, which saw a steep fall during the period of the currency shortage, may rebound sharply. He also highlighted that non-food non-fuel inflation has remained sticky. Domestic factors, put together with the increase in global commodity prices has raised the risks to headline inflation, said the Governor.

At the same time, remonetisation could lead to a pick up in economic activity in the January-March quarter, with discretionary consumer demand likely to revive.

Against this backdrop, Patel supported a status quo in the repo rate. While the RBI now has the 4 percent inflation target in sight, it is necessary to adopt a “calibrated approach” to reduce the collateral costs.

Viral Acharya and Michael Patra, the other two RBI members on the committee shared this view.

A neutral stance allows RBI to "remain fully flexible to raise rates, or to stay put, or to cut rates, as more data becomes available on both domestic and international fronts,” said Acharya in his statement. Patra noted that it is “vital to unfetter monetary policy from a unidirectional stance.”

Both judged the fall in headline inflation to be largely temporary and felt that this effect would wear off as the remonetisation process moves forward. Retail inflation has fallen to a series low of 3.2 percent in January due to a sharp fall in prices of perishable items. Core inflation, however, has remained close to 5 percent, making it tough for the RBI to move towards the 4 percent inflation target set by the new monetary policy framework agreement.

“Compared to the balanced assessment in December 16 minutes, the February 17 minutes appear relatively hawkish with all members highlighting upside risks to inflation amid stickiness in core inflation,” wrote Shubhada Rao, chief economist at Yes Bank in report released after the release of the minutes.

Was There A Divergence In Views?

Like the first two meetings of the MPC, the third meeting also saw all six members voting in sync. The decision to keep the policy rate unchanged was supported by all members. The statements issued by two of the six members, however, made no mention of their views on the change in stance. Unlikely global precedent, the MPC minutes in India are released in the form of statements from individual members and not in the form of a chronicle of the meeting.

Pami Dua, in her statement, said that remonetisation is progressing well as seen by the increase in the ratio of currency in circulation to GDP. She also noted that the surge in banking sector liquidity has led to a drop in lending rates. Dua said that she voted to hold the policy rate at 6.25 percent keeping in mind that backdrop while also accounting for upside risks to global inflation and the likelyhood of rate hikes from the US Federal Reserve.

Chetan Ghate was also of the view that the temporary (adverse) effects of demonetisation are getting reversed as the economy remonetises. The permanent effect, which will operate through wealth destruction, is a little more uncertain, he noted while adding that this permanent adverse effect is unlikely to be large in the long run.

In her report, Rao of Yes Bank noted that the change in stance appears to be a majority decision and not a unanimous one.

“ ..on closer scrutiny of the minutes, it appears that the decision to change the monetary policy stance to ‘neutral’ from ‘accommodative’ was not unanimous, but a majority one, with four out of six members favoring an explicit shift in stance,” she wrote.

While the status quo on rates surprised some, it was not entirely unanticipated. What took the markets by surprise was the change in stance. The benchmark 10-year bond yield has risen 50 basis points since the day before the policy announcement. On Wednesday, the 10-year yield closed at 6.93 percent - the highest since September 2016.