Monetary Policy Framework: It takes two to tango
March 4, 2015, 7:15 AM IST Economic Times in ET Commentary | Economy | ET
By Madan Sabnavis
The agreement on monetary policy framework signed by the government and Reserve Bank of India (RBI) is significant because this is the first time such a thing has been done. Curiously, this was a recommendation of the internal committee set up by RBI earlier, and, hence, is not coming from the top but is an internally agreed-upon move. The RBI has already been targeting CPI inflation; the difference is that it will be responsible for the inflation number. This is the addition to the storyline. It is extremely interesting to watch how this will play out, for four reasons.
First, the RBI will be targeting the CPI inflation number whose composition is such that its own policy may have limited power to influence. The new index, with 2012 as base, assigns weights of 48.3% to food-related items, 10.1% to housing and 6.8% to fuel and light, which are not leveraged. This accounts for around 65% of the index. Clothing, with a weight of 6.5%, may be leveraged through cards and another 3-4% of the miscellaneous category (weight of 28.35) which includes handsets, television, refrigerators, could be on credit. Therefore, not more than 10% of the index, which is being targeted, could be amenable to monetary policy action.
Further, in FY14 for instance, the items outside the RBI’s purview accounted for over 98% of inflation. While interest rate action should be linked to inflation on grounds of prudence to ensure positive real interest rates, expecting the repo rate to control inflation which is largely driven by supplies, government action (crude oil and related products) and extraneous forces is a challenge.
Second, there is sound reason for having a target of 4% with a band of 2% at either end. However, an economy which has not invested much in agriculture will always be susceptible to supply shocks from farm products. In the past 10 years, we have had CPI inflation for industrial workers at less than 6% only twice, and, in fact, in the past eight years it has always been higher than 6%. Are we challenging ourselves considering that 4% looks like a tall order?
Third, the inflation targeting has to be done while also ‘keeping in mind the objective of economic growth’. This poses a conundrum. Going by, say the old GDP series, when growth had slowed down to 4.5% and 4.7% in FY13 and FY14, respectively, which coincided with CPI inflation numbers of 10.2% and 9.5%, would the monetary authority have been expected to keep increasing rates continuously or just retain rates at
high levels? It would never have been possible to explain why monetary policy could not bring down inflation especially since products like tomatoes and onions pushed up inflation, over which monetary policy has no control.
Fourth, the RBI has often commented on the policy transmission mechanism being weak. Therefore, when the RBI lowers or increases rates by 50 bps, the response in bank deposit and lending rates is not proportional. The repo rate affects them to the extent of say 1% of NDTL which is around `80-85,000 crore, which is accessed through the daily LAF and term repo facilities. Would this then mean the RBI has to lower the LAF facility in case it realises banks are not increasing rates when the repo rate is increased? It is because of this sluggish mechanism that there are dualistic images in the market — an increase in repo rate leads to G-sec yields increasing even while banks may not be doing so with their rates. An interesting conjecture to make is on the response time for policy action in future. If inflation goes up to say 6.2% for February, would this mean the trigger will be
pulled even before the policy? The market will start guessing more on the 12th of every month when the CPI numbers are released and that will add zing to an otherwise sedentary money market.
(Published in EconomicTimes.com)
March 4, 2015, 7:15 AM IST Economic Times in ET Commentary | Economy | ET
By Madan Sabnavis
The agreement on monetary policy framework signed by the government and Reserve Bank of India (RBI) is significant because this is the first time such a thing has been done. Curiously, this was a recommendation of the internal committee set up by RBI earlier, and, hence, is not coming from the top but is an internally agreed-upon move. The RBI has already been targeting CPI inflation; the difference is that it will be responsible for the inflation number. This is the addition to the storyline. It is extremely interesting to watch how this will play out, for four reasons.
First, the RBI will be targeting the CPI inflation number whose composition is such that its own policy may have limited power to influence. The new index, with 2012 as base, assigns weights of 48.3% to food-related items, 10.1% to housing and 6.8% to fuel and light, which are not leveraged. This accounts for around 65% of the index. Clothing, with a weight of 6.5%, may be leveraged through cards and another 3-4% of the miscellaneous category (weight of 28.35) which includes handsets, television, refrigerators, could be on credit. Therefore, not more than 10% of the index, which is being targeted, could be amenable to monetary policy action.
Further, in FY14 for instance, the items outside the RBI’s purview accounted for over 98% of inflation. While interest rate action should be linked to inflation on grounds of prudence to ensure positive real interest rates, expecting the repo rate to control inflation which is largely driven by supplies, government action (crude oil and related products) and extraneous forces is a challenge.
Second, there is sound reason for having a target of 4% with a band of 2% at either end. However, an economy which has not invested much in agriculture will always be susceptible to supply shocks from farm products. In the past 10 years, we have had CPI inflation for industrial workers at less than 6% only twice, and, in fact, in the past eight years it has always been higher than 6%. Are we challenging ourselves considering that 4% looks like a tall order?
Third, the inflation targeting has to be done while also ‘keeping in mind the objective of economic growth’. This poses a conundrum. Going by, say the old GDP series, when growth had slowed down to 4.5% and 4.7% in FY13 and FY14, respectively, which coincided with CPI inflation numbers of 10.2% and 9.5%, would the monetary authority have been expected to keep increasing rates continuously or just retain rates at
high levels? It would never have been possible to explain why monetary policy could not bring down inflation especially since products like tomatoes and onions pushed up inflation, over which monetary policy has no control.
Fourth, the RBI has often commented on the policy transmission mechanism being weak. Therefore, when the RBI lowers or increases rates by 50 bps, the response in bank deposit and lending rates is not proportional. The repo rate affects them to the extent of say 1% of NDTL which is around `80-85,000 crore, which is accessed through the daily LAF and term repo facilities. Would this then mean the RBI has to lower the LAF facility in case it realises banks are not increasing rates when the repo rate is increased? It is because of this sluggish mechanism that there are dualistic images in the market — an increase in repo rate leads to G-sec yields increasing even while banks may not be doing so with their rates. An interesting conjecture to make is on the response time for policy action in future. If inflation goes up to say 6.2% for February, would this mean the trigger will be
pulled even before the policy? The market will start guessing more on the 12th of every month when the CPI numbers are released and that will add zing to an otherwise sedentary money market.
(Published in EconomicTimes.com)
No comments:
Post a Comment