The MPC...Its Mandate And Beyond 

BloombergQuintOpinion

When it sits down for the October review, India’s Monetary Policy Committee would have completed two years since its inception in 2016.

As the six-member panel begins its third and final year, it faces an economic environment far more complex than it did in the last two years. There is no reason to believe that the committee is not up to the task of managing these complexities. However, its hands may be tied by a relatively straight-jacketed ‘flexible inflation targeting’ framework.

Before discussing the current scenario across the economy and the currency and credit markets, a brief digression into the debate that took place before India adopted a formal inflation targeting framework.

Not everyone was in favor of such a framework. Two former RBI governors -- Bimal Jalan and YV Reddy -- had expressed their reservations. Jalan had questioned the extent to which monetary policy can influence inflation in an economy like India, where food and fuel continue to make up a large part of the consumption basket. Reddy had questioned whether inflation targeting would make the RBI - a full-service central bank - too focused on one indicator.

Central bank watchers will remember that in the pre-inflation targeting days, the RBI would toggle between its multiple objectives, based on the prevailing environment. In the new regime, the ability to do that is limited, at least for the MPC.

That brings us back to the present.

When the MPC sits down to decide its next move, it would need to do three things:

  1. Act within its mandate.
  2. Account for what may come along with its mandate, which, in turn, could impact its ability to meet its mandate.
  3. Decide whether it wants to weigh in on structural issues, technically beyond its mandate.

The Mandate...

The objective of monetary policy framework is to primarily maintain price stability, while keeping in mind the objective of growth.” That’s the short description of the mandate of the MPC based on the agreement signed between the RBI and the government in February 2015.

The agreement gives the MPC flexibility in the inflation target by allowing it to maintain inflation within a band of 4 (+/- 2) percent. But it accords no flexibility on the indicators that the MPC must target. It also does not provide much flexibility on the tools at the MPC’s disposal. According to the agreement that tool is the benchmark policy interest rate, i.e. the repo rate.

RBI Governor Urjit Patel reiterated the commitment to this mandate in June. “Our monetary policy is determined by the nominal anchor that has been given to us through a legislative process and which is the consumer price index,” Patel said when asked whether the RBI would use interest rates as a defense against a weakening currency.

If you take that statement at face value, the MPC would take stock of current inflation and inflationary expectations. It would analyse the inflation impact of a weakening currency. It would build in any domestic price implications of higher import tariffs announced to deal with the widening current account deficit.

If those, or any factors such as higher minimum support prices or the likelihood of fiscal slippage, lead the MPC to believe that inflation will remain above its target of 4 (+/-2) percent by the end of the financial year, it would hike rates for a third consecutive meeting. The quantum of the rate hike would depend on the extent to which inflation would be expected to outstrip the target.

The current inflation targeting regime and the RBI’s liquidity management framework are adequate to balance out the pulls and pushes, said Sajjid Chinoy, chief India economist at JPMorgan. “Under the inflation targeting framework, rates would need to go up. We expect another 25 basis points and potentially a change in their stance away from neutral,” said Chinoy.

This will help confront inflation. It will also, at the margin, help temper aggregate demand and bring down the current account deficit to a more sustainable level.
Sajjid Chinoy, Chief India Economist, JPMorgan

Along With The Mandate....

Should the MPC choose to stick to the letter and the spirit of its mandate, it may not be in a position to address specific trouble spots in the economy and markets. That task may fall on the RBI.

Take, for instance, the tight liquidity conditions and the nervousness in credit markets. The MPC may choose to turn hawkish, drop its neutral stance and hike rates in keeping with its inflation mandate. This could add to the troubles of the non-banking sector, which would see refinancing rates rise and margins slip. The RBI may not be averse to higher rates, which would be consistent with the monetary policy stance, but it may also need to step in with liquidity support.

It will likely continue buying government bonds via its open market operations to ensure liquidity remains close to neutral or in mild-deficit mode. If the situation worsens, it may also need to consider options to ensure the smooth flow of credit to segments like NBFCs and mutual funds.

On the flip side, should the MPC take the unlikely call of keeping rates on hold, the rupee weakness may worsen and the RBI may need to step in more aggressively to support the currency. That may be in the form of larger dollar sales or an extra-ordinary measure like a special window to attract dollars from non-resident Indians.

Ananth Narayan, associate professor of finance at SP Jain Institute of Management and Research says that the starting point to address the current set of problems is hawkish monetary policy. This, however, may need to go together with the use of buffers such as forex reserves or liquidity facilities, to buy time till structural issues are corrected.

We have a financial stability problem. At a time like this, we cannot be seen to be lax or behind the curve. We cannot afford to have demand go up. We have to curtail demand through monetary and fiscal policy. In the meantime, we have buffers which we can used to buy time to fix the structural imbalances.
Ananth Narayan, Associate Professor, SP Jain Institute of Management and Research

Beyond The Mandate...

While the MPC may choose to restrain its actions to fit its mandate, should it choose to weigh in on longer term structural issues? More specifically, the current account deficit.

Does the MPC see the current account deficit as a consequence of a savings-investment imbalance? If so, does it foresee the need for higher rates to correct that imbalance? Does it want to debate the export-import imbalance and move towards aggregate demand just as the investment cycle is picking up?

Chinoy believes that it can do all this through the lens of inflation and growth. “The current account imbalance is simply reflecting an imbalance that investment is higher than savings. Those imbalances also get reflected in core inflation,” said Chinoy, while adding that by tackling inflation you are also indirectly tackling the external imbalances. The MPC should stick to that approach rather than confusing the markets with different indicators.

In the midst of global uncertainty, you don’t want to add policy uncertainty....The last thing you need is going back to the confusion of the multi-indicator approach where the markets were constantly guessing what the RBI will be reacting to.
Sajjid Chinoy, Chief India Economist, JPMorgan

Ananth Narayan added that the RBI and the MPC are doing a good job. They are being conservative and cautious in their approach, said Narayan. He, however, added that there is no denying the ‘impossible trinity’ between monetary policy, capital flows and the currency markets which cannot be overlooked.

Watch the discussion with Sajjid Chinoy and Ananth Narayan.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.