Transmission loss

Administered interest rates are a bigger concern

As the Reserve Bank of India approaches its bi-monthly monetary policy announcement next week, there is a virtual unanimity of expectations that the benchmark repo rate will be cut by 25 basis points. With the policy framework having adopted the rate of inflation measured by the Consumer Price Index as the predominant determinant of action, there is little ambiguity on this question. The August reading for this indicator was 3.66 per cent, far below the target set for March 2016 and even below the long-term target of four per cent, plus or minus two per cent. Although RBI Governor Raghuram Rajan has said that this is partly because of a favourable base effect and that the underlying dynamic suggests a rate of five per cent or so, the fact is that none of the risks - food and commodity price surges - that the RBI has expressed concern about have materialised significantly thus far. Having laid down an explicit policy framework, monetary policy actions have to be consistent with it and many observers have argued that the RBI is significantly behind the curve in reducing rates. Be that as it may, the unexceptionable course of action on September 29 will be to reduce the repo rate.

That said, there are some larger issues that the RBI needs to think about in the context of the overall efficiency of the policy process. Dr Rajan has been vocal about the weakness of the transmission from policy actions to lending rates. Although many banks have responded to his moral suasion by cutting their rack rates, this is hardly a robust mechanism. There are a number of structural constraints to effective transmission, an important one being the rigidity in several rates that are still administered - like the ones on provident funds and small savings. Despite long-standing recommendations to link these to market rates, the government has simply failed to act. Dr Rajan needs to target the policy establishment on this issue as much as he does the banks; the prevailing system is completely inconsistent with the quest for an efficient, market-based interest-rate transmission mechanism.

Another issue that needs to be revisited is the bimonthly frequency of monetary policy announcements. Yes, a higher frequency can help to make the process more sensitive and responsive to macroeconomic developments, but it is not clear at all that the current scheduling achieves this. To the extent that new data provide the foundation for a policy decision, the release of the Index of Industrial Production data and, most critically, the Consumer Price Index data, takes place between the 10th and 15th of each month. Even if the RBI wants to see two monthly releases before making a decision, it surely does not take three weeks to process this information. This is currently the average lag between each bi-monthly announcement and the most recent data release. This may have contributed to a couple of out-of-schedule actions, which, while displaying responsiveness, created some confusion in the markets. If even six announcements a year do not preclude out-of-schedule actions, both frequency and scheduling need to be re-considered. Reverting to a quarterly schedule, perhaps, would not be a bad idea.