With respect to what the Reserve Bank of India (RBI) needed to do in yesterday’s quarterly monetary and credit policy announcement, it was the editorial opinion of this newspaper that the repo and reverse repo rates as well as the cash reserve ratio should be reduced in order to maintain the momentum that had been provided by similar actions in recent weeks. The macroeconomic situation, with growth unquestionably slowing and inflation fading rapidly, was ripe for an interest rate reduction. The only question was by how much. From a market perspective, however, polls of participants taken during the build-up to the announcement suggested that a large number, if not a majority, did not expect the RBI to do any such thing. Their opinions appear to have been driven by the perception that, scheduled announcements notwithstanding, the RBI acts when there is a clear provocation in the form of adverse information flowing in. In the event, the RBI lived up to the status quo expectations, changing neither the rates nor the ratio. Markets were clearly unaffected, with the major stock indices increasing by a robust 3 per cent or more during the day. But, market response aside, the macroeconomic rationale for the RBI’s inaction warrants some examination.
On the face of it, the RBI is somewhat more pessimistic than the other two government agencies that have put out macroeconomic forecasts. The finance ministry recently estimated that growth during the current year would be in the 7-7.5 per cent range, a view reinforced by the Prime Minister’s Economic Advisory Council. By contrast, the RBI’s own macroeconomic review, released on the eve of the policy announcement, pegged growth during the current year at 7 per cent, but seemed to emphasise downside risks, implying that that number was an upper limit. It also painted a rather rosy picture of the inflationary situation, indicating that the inflation rate could drop to 3 per cent or lower by March. These outlooks together made a strong case for continuing with the easing stance; there was very little to lose and everything to gain. From this perspective, there is a significant dis-connect between the RBI’s macroeconomic assessment and the actions it has taken, or not taken.
The decision to maintain the status quo appears to have been motivated by the fact that, despite significantly large amounts of liquidity having been pumped into the banking system, most recently on January 2, credit flows are yet to increase appreciably. The governor’s statement pointed out that the RBI’s rate cuts are yet to be adequately transmitted through to consumers of credit; some banks have begun reducing rates, but others are yet to do so. In effect, this points to the futility of further rate cuts and liquidity enhancements. The statement provides the assurance that ample liquidity will be maintained, suggesting that the central bank is not yet done with easing. However, to maximise the impact of further cuts, it would prefer to wait until increased credit flows begin to exert pressure on liquidity again, putting banks in a position of having to borrow from the RBI through the repo rate. At that point, reducing the repo rate would make a difference.
On balance, the RBI should have acted in a manner consistent with its macroeconomic assessments, ie, it should have cut rates and perhaps also the cash reserve ratio. While its rationale with respect to sluggish credit flows may have some merit, not making any changes risks sending mixed or even wrong signals to the market. On the one hand, it can deter borrowing because people expect further cuts sooner rather than later and are willing to wait for them. On the other, a neutral monetary stance, which this one effectively is, can be taken as a sign that the worst is over, which it clearly is not. But, beyond this, two other factors must be considered. First, if the real problem is credit flows and sticky market interest rates, solutions must go beyond mere exhortations. Second, if scheduled announcements are not being used as occasions to trumpet policy changes, perhaps the schedule itself is redundant in these turbulent times.
