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Monetary Policy: Is ‘Calibrated Easing’ In Store?


Over the months of November 2018 and February 2019, Consumer Price Index inflation in India averaged at 2.2 percent. With headline inflation printing close to the lower bound of the mandated inflation target band of 4 percent (+/-2 percent) for four consecutive months, the Monetary Policy Committee of the Reserve Bank of India abandoned its ‘calibrated tightening’ stance and adopted a ‘neutral’ stance in February. This was accompanied by two rounds of 25 basis points cut in the repo rate, with the last cut delivered in its April policy review.

While the latest round of monetary easing by the RBI was completely priced in by market participants, I am reasonably confident that the underlying drivers could have come as a surprise to quite a few.

Let me elaborate. As per the March round of RBI’s Survey of Professional Forecasters, the consensus expectation for CPI inflation for Q4FY20 is at 4.2 percent. This is higher than RBI’s inflation estimate of 3.8 percent for the same period provided in its April policy review.

Not just the end-point, the entire inflation curve anticipated by the central bank—which incidentally was shifted lower vis-à-vis the previous policy in February—seems to be lower than that expected by the professional forecasters.

Assuming that no new publicly available inflation sensitive information has become accessible in the last couple of weeks, this divergence of 40 basis points between market consensus and the RBI should have ideally indicated a somewhat aggressive monetary easing response instead of the 25 basis point cut. Inflation has been consistently undershooting the mid-point of the target for seven consecutive months while at the same time, it is projected to remain below the mid-point of the target until March 2020. Additionally, this undershooting is happening at a time when the output gap is supposed to be negative, which further reinforces the argument for aggressive monetary easing.

Why Wasn’t RBI More Aggressive?

It appears that the following macro-financial considerations could have weighed against aggressive monetary easing by the RBI in April 2019:

  • Preliminary observations by key weather agencies across the world suggest some likelihood of El Nino related disturbance to India’s monsoon outlook. India’s private weather forecaster Skymet released its early forecast for Jun-Sep 2019 monsoon season, as per which the rainfall out-turn is expected to be ‘below normal’ at 93 percent (of long period average).
  • There is considerable uncertainty on the outlook for crude oil and international trade.
  • The fiscal consolidation process is undergoing a pause even as the quality of fiscal adjustment is set for some deterioration amidst the rollout of a consumption stimulus.
These uncertainties would keep MPC under a data-dependent mode with the stance of policy neutrality according it the flexibility to provide incremental need-based accommodation if the above-mentioned inflation risks do not play out. 

This inspires me to revisit the above-mentioned notion of calibrated tightening. In the Oct 2018 policy review, the RBI had articulated that:

“Calibrated tightening” means that in the current rate cycle, a cut in the policy repo rate is off the table, and we are not obliged to increase the rate at every policy meeting.

While the MPC has retained its neutral policy stance in the April 2019 policy review, it is worth debating if the current environment provides an antithesis in the form of “calibrated easing” of the monetary policy stance. Taking the liberty to paraphrase:

“In the current rate cycle, a hike in the policy repo rate could be off the table, and the MPC might not be obliged to cut rate at every policy meeting.”

This is something which is not specific to India alone. In the last three-four months, central banks in key economies have either turned decisively dovish (like the European Central Bank), or eliminated hawkishness completely (like the U.S. Federal Reserve). Barring Brazil and the Nordic countries of Sweden and Norway, most other central banks are expected to ease momentary policy over the course of the next year. This is in sharp contrast to consensus expectation of rate hikes for most of these economies during the months of October-December 2018.

Liquidity Management

While the actual policy stance might be a function of incoming macro-financial information from both domestic and global sides, the RBI has moved towards supporting liquidity in the banking system to enhance monetary policy transmission. In this context, the infusion of primary liquidity via open market operation purchases (Rs 2,98,500 crore) and forex swap ($5 billion) in FY19 along with the announcement of another $5 billion forex swap (scheduled later this month) is a step in right direction.

Allowing banks to reckon an additional 2 percent of government securities within the mandatory statutory liquidity requirement as Facility to Avail Liquidity for Liquidity Coverage Ratio for the purpose of computing the liquidity coverage ratio (in a phased manner) will not only enable effective management of liquidity by bank balance sheets, but it would also raise the potential lending capability of banks, thereby supporting the flow of funds to the economy. With the proactive deployment of liquidity easing tools, liquidity neutrality is likely to be achieved over the course of the next month.

Shubhada Rao is group president and the chief economist at YES Bank.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.