Policy, Put the Kettle On

CONTEXT: Reserve Bank of India (RBI) may soon have a new Monetary Policy Committee (MPC) deciding the future of interest rates.

Problems faced by the MPC:

• Difficulty in Inflation targeting: As per Flexible Inflation Targeting (FIT) framework adopted in 2016, MPC had to manage retail inflation within a band of 2-6%, while it could barely achieve the median.

• Interest rates remained higher than optimal for extended periods.
• This, in turn, hampered growth and kept the rupee overvalued as higher domestic interest rates attracted foreign debt investors.

• Supply Constraints: Both temporary and permanent constraints mean that there are periodic spurts in some prices that push up headline inflation.

• These supply problems could show up in items as diverse as onions and healthcare.
• Trying to control sudden spurts in prices of unrelated products through interest rates and rule-based approach is like playing a game of whack-a-mole.

• Core inflation as Alternate target: The idea of core inflation may be unfamiliar to the non-specialist and defeat the objective of making monetary policy transparent and comprehensible.

• Low Bond yields: In the past month, in the four auctions of the benchmark 10-year paper, RBI offered yields that found no takers. 

• The central bank uses the cut-off price in an auction — or, the return security offers to lenders — as a signalling device:

• A higher return (or bond yield) is a hint that RBI is comfortable with a higher interest rate, and vice versa.
• A lower bond price (due to excess supply) means higher yields requiring banks to book mark-to-market losses.
• Investors are still cautious of the fall in the bond-yield in the aftermath of demonetization.

• No power over liquidity: MPC only takes a call on the repo rate.

• Whereas RBI takes all liquidity decisions, determining whether banks are cash short and need to borrow from the repurchase, or repo, window (at the repo rate), or whether they are cash surplus and want to park this at the reverse repo window.

• Dealing with the Crises: The RBI has been busy with the multiple objectives of-

• Targeting liquidity to critical segments.

• Ensuring banks have adequate cash to lend to revive the economy.
• Managing government bond yields.

Way Forward:

• Flexibility as the cornerstone of the new monetary policy framework.
• Encourage market participation: by keeping the interest rates low, coupled with 

• An OMO timetable.
• Slower sterilization of liquidity (created when RBI buys dollar).
• Issue of more treasury bills (compared to long-term bond).
• Underplaying inflation targeting.
• Doing a token rate cut.

• Ensure coordination between the policy rate and the amount of liquidity, as the price of money is affected by both.

• Instead of targeting the overnight rate, RBI could get a faster transmission by targeting a three-month rate, say, the three-month Treasury Bill rate.

• For, E.g. Until 2019, the Swiss National Bank, targeted a three-month rate, the Swiss Franc LIBOR.

Conclusion: Economic crises offer both an opportunity for reform, and a revamp of institutional frameworks. Indian monetary policy warrants close scrutiny.