The decision-making process on interest rates has become difficult to gauge across various credit policies. There are now six MPC members each with their independent views that look at the same data and draw conclusions which finally lead to a vote. It is generally agreed that there should ideally be a surprise element to make monetary policy effective. But this never seems to be happening. In fact, the recent rate cut has not made the market happy as there were expectations that there would be a sharper reduction in interest rates. What does the text book say? Theoretically, Keynes would not rely too much on interest rates as a solution and would be in the minority today as almost all economists are batting for rate cuts all the time. When the problem is on the demand-side, lowering interest rates does not add a delta to growth but probably helps companies lower their interest cost. This factor is never mentioned in the policy document even though it is critical for the transmission purpose. Ideally, there should be models that draw such conclusions to justify that rate cuts have helped increase investment or growth, which is what the main objective is supposed to be.
Monetarists like Friedman would be confused because if inflation is within the target of 4%, he would never understand why markets are so volatile when RBI does not oblige according to expectations. Rational expectations proponents like Robert Lucas and Thomas Sarjent would cynically smile and say what they always believed, that monetary policy does not matter. Their stance was that the central bank can make policy effective only by ‘fooling the market’, which it has never done because the market is always expecting more. Maybe, RBI should bring interest rates down to nil like the Fed or ECB have done in the past to placate the markets, though, to be sure, such a measure did not work in these regions for over a decade!
What does the MPC look at? It is the CPI inflation number of 4% which is the mandate. Curiously, whenever a judgment call is taken on rates, there is no mention of real interest rates, which would be the logical way of interpreting inflation targeting for monetary policy. This is so because almost 80-85% of the index does not work on credit and is not influenced by repo rate or MCLR, unlike the WPI. Hence, linking the two makes sense when it is agreed that policy should be reactive to inflation from the concept of real interest rate. Interestingly, almost every policy statements talk a lot on vegetable inflation—potatoes, onion and tomatoes which are the usual suspects, and protein inflation (a new concept coined in our lexicon to refer to pulses like tur and urad) when interest rates cannot influence their prices and are beyond the banks’ purview. If tomato prices touch `100/kg, nothing can bring down the prices until supplies improve. One may, hence, infer that it is the real rate which the central bank or the MPC has in mind when evaluating interest rates.
How is a judgment call taken? The market, as well as the government, asks for a rate cut six times a year which is a habit now. So, how does one interpret inflation movement especially if it is within the region of 2-6%? Should RBI cut rates when it moves from 4% to 3.5%, or is it only when it is less than 2%? As a corollary, should the MPC recommend increasing rates, when the inflation rate moves to say 4-4.5%, which is what the statement talks of? But this will not be done for sure, which makes conjecturing the minds of the MPC even more challenging. Must monetary policy be forward-looking? The guidelines talk of targeting CPI inflation though it is not mentioned whether this number should be prevailing at the time of decision-making or expected to prevail over a period of time. One can guess that a futuristic view is taken of at least two months, and hence, while the 1.5% number is satisfying, it should be expected to be range-bound for a decision to be taken by lowering rates.
How does one interpret the issues flagged in the statement? There is always a qualification provided which takes the stance on which factors are important to watch out for or the issues that have been responsible for taking a call. Here the picture gets more interesting. In the June policy, two unknowns that were flagged were GST impact on inflation and the Pay Commission payouts which were to be invoked in July. The present policy statement talks of ‘rollout of GST being smooth’. Arguably, as the July inflation numbers are not yet out and the fact that any new tax system works with a time-lag, the call now is that GST will not matter. For the HRA payouts, the view is that while this would have some impact, the inflation number will still hover around 4%.
It can be counter-argued that as there has been no new information in the last two months that could justify these conclusions the rate cut decision could have been taken in June itself. Should the composition of the MPC be widened? Currently, besides RBI representatives, there are academicians present on the committee. A thought here is that either the committee can be expanded or a new category of members be brought in to represent industry, banks and households. In fact, as the entire policy statement is based on interpretation of inflation in the context of growth, there is a corporate proclivity, while financial savings talk gets left out which affects over a billion people—who the system is trying to gravitate to the banking system under the umbrella of financial inclusion.
Last, do we need six such policies? This issue has been debated even earlier. While global central banks meet 4-8 times, India had the practice of two policies for a very long period of time until 2004-05, when we moved to quarterly policies. Then we moved to eight policies before settling for six policies a year. The idea was to reduce the noise element in the markets. However, as the market tries to get ahead of the curve every time, the noise factor has increased which affects not just the stock market, but also the G-Sec market where large volumes of money get impacted. There is a compelling reason to go back to quarterly or half-yearly policies with RBI retaining the prerogative to change rates as the situation demands. Monetary policy outcomes will continue to be unpredictable as the words in the statement get interpreted furiously by all market participants. As the good times are expected to prevail as per the script that has been put out, more rate cuts should logically be expected this year, though one can never be sure how the MPC reads the same prism next time.