The Reserve Bank of India's second bi-monthly monetary policy statement for the year 2016-17 earlier this month held no surprises: it was, as every one claimed in the media, on expected lines. That the policy announcement coincided with analysts' expectations should, however, be viewed with some concern, though the Governor claimed that his statement was 'realistic'. The event should have been used to be more creative. That would have enhanced the reputation of the RBI as a driver of new ideas and of the path of market behaviour. That this did not happen is disappointing. Instead, the statement indulged in a cliche used by modern central banks, i.e., that there are upside risks of inflation not wholly counterbalanced by 'potential disinflationary pressures', to use the Governor's words.
The statement appeared to merely repeat the thrust of the first policy statement in April. No questions were asked about growth prospects. The statement accepted the weather man's forecast of good monsoons. But it is the April inflation data that seemed to have surprised RBI. Why? Could it be a seasonal factor or a factor caused by climate change? Are there other factors that cannot be identified at this point of time in the observed phenomenon?
Food and commodity price increases seem to be the cause of high inflation expectations now, but may peter out if agriculture performs well and oil prices remain within a tolerable range, so that the inflation target for March 2017 is achieved. Such an explanation is superficially plausible but not credible. For, inflation expectations may peter out if agriculture registers productivity gains even if the monsoon is moderately positive and if exogenously determined international commodity prices do not hit the roof this year, as many observers believe. But expectations are also shaped by other factors, such as the seemingly sound fiscal discipline and the reasonable optimism of international financial institutions and foreign investors about India's performance.
Gauging inflation expectations is not as simple as one makes it out to be. It need not be 'adaptive' or 'rational' and need not also be in conformity with the surveys that central banks conduct. Information from such surveys has not proven reliable in advanced economies in recent times. It is for this reason that one needs to revisit the methodology underlying the Indian survey data. Are the behavioural responses of the respondents in line with the possible explanations of behavioural economists?
Some analysts felt at the time of the first policy statement in April that interest rate changes have not transmitted the desired effects and the RBI has therefore shifted its attention to quantity variables in the form of providing liquidity to fill the funding gaps. To a purist, provision of liquidity to banks in need of funds is a central bank's 'dharma'. It is well-known that all central banks prepare liquidity assessments or projections based largely on movements in the components of reserve money at least once every working day, to provide insights about money market conditions. The RBI has also been conducting such exercises for almost twenty years. Central banks carry out such exercises either to suck out surplus liquidity or to fill up deficits in liquidity. If deviations between liquidity assessments and liquidity requirements are high, then the template of liquidity projections would have to be recast. Most central banks have succeeded in minimising deviations, thanks to a good dissemination of techniques of monetary operations over the last two decades or so.
Very few central banks, however, venture into systemic or durable liquidity assessments and though the Governor hinted that such assessments are a work in progress, one wonders how cluttered this template would be, given the fact that fiscal, private sector and foreign sector operations would have liquidity effects of different durations and the effects could be felt not only on the money market but also on other financial markets (the bond market, for example). It would be operationally difficult to evolve a template that helps central banks to ensure that liquidity needs are neither in a surplus nor a deficit position, but are in a neutral zone that cannot easily be determined a priori.
One gets a sneaking suspicion that the policy statement was not so much to serve to improve the monetary transmission mechanism as to secure breathing time for sorting out banking stability issues and to constrain banks from lending without due diligence. The RBI could also take the opportunity to work out better internal mechanisms to improve its supervision and regulatory framework, so that the current situation of 'breaking news' about banking sector stress does not repeat itself. Good supervision should always be concerned about asset quality and forbearance, and lowered provisioning requirements should be avoided. Once these are taken on board for implementation in the very short term, one could well ask as to what would have happened if the official rate had been reduced by the usual 25 basis points or the cash reserve ratio lowered by 25 basis points. Is such a step unwarranted because growth prospects are good and April inflation was high? Or, is there fear and uncertainty that the review of the FRBM Act would release more fiscal space and render the task of monetary policy so much more difficult?
If the banking stability issue is at the heart of the pause in monetary policy making, it would be the first test case of a possible approach to bring together macro-prudentials and monetary policy. If this is not so, let the rationale for the policy pause be explained in clear terms and, if needed, in detail, because the markets should be influenced to pursue the path that monetary policy makers see as critical for achieving the three objectives of price stability, growth and financial stability. The second policy statement is a disappointment in that it did not care to explain its rationale in clearer terms.
The writer was Executive Director, Reserve Bank of India, and advisor to the Central Bank of Nigeria
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
