Monetary Policy – Much More Than the Rate Cuts

For both the financial markets and the public at large, the monetary policy announcements are primarily about the interest rate changes.

Credit: Reuters

A specific monetary policy concern for individuals lies in the interest rate changes. Credit: Reuters

The second monetary policy statement for the year 2016-17 was announced by the Reserve Bank of India (RBI) on June 7. The previous policy statement was announced in April when the central bank lowered the policy repo rate by 0.25 percentage points. On the eve of the latest policy, expectations were therefore, muted. A further reduction in the policy rate was simply not on the cards.

Some non-event this 

The RBI’s inaction, converting the policy announcement into another ‘non- event’,  did not surprise anyone as it was entirely in line with the expectations. The policy repo rate, always in focus at the time of policy statements remains at 6.5% (repo rate is the rate at which the RBI lends to banks on a short-term basis), while the reverse repo rate (rate at which the central bank borrows from the market) is unchanged at 6%. Other much less frequently used rates – the marginal standing facility and the bank rate both remain at 7%.

For both the financial markets and the public at large, the monetary policy announcements are primarily about the interest rate changes. In fact, for the later category – the man on the street – the perception has gained ground that there is nothing more to policy statements than an occasional rate cut. What has been missing is an understanding of the nuances of policy statements and how an appreciation of these is essential to evaluate the macro-economic strength and weaknesses.

For the government, there is much to be gained if the economic policies are demystified so as to be understood by even by common people. The financial markets, of course, rely a lot on the policy statements. The RBI is the most authentic purveyor of macro-economic data and enjoys substantial credibility.

It is essential to stress that no monetary policy statement ought to be viewed in isolation. Each is part of the larger monetary policy framework. This is especially relevant in the backdrop of the inflation target, signed by finance minister Arun Jaitley, with the RBI acting as a custodian.

Don’t expect a rate cut soon

The latest policy statement is significant in another way. A reading of the statement shows that there may not be a rate cut for sometime. Most experts agree on this, pointing out that during the remainder of this fiscal year (2016-17), there is scope for only a meagre 0.25 percentage point cut in the repo rate, if at all.

That makes it all the more necessary to appreciate the RBI’s arguments in arriving at its ‘no’ interest rate change stance. For the markets, the interest rate changes might still be the focus. However, in a refreshing change, it is not the interest rate changes alone that matter. What is behind the RBI’s thinking also matters, probably to an even greater degree. An understanding of the RBI’s logic leads to a better appreciation of the macroeconomic dynamics.

Inflation the key worry

The single most important reason is the fear of inflation. The recent data indicates a rise in domestic food and oil prices. Global oil price has crossed $50 a barrel and this has already caused a sharp increase in the domestic retail prices of petrol and diesel. While the RBI is concerned with the unexpected upward movement of inflation, it has not changed its year-end forecast of 5.1%. The reasons are not hard to seek – the outlook for monsoons, which has just arrived is favourable.

The government has initiated a number of supply side measures such as the introduction of a national agricultural market trading portal which can help in minimising the sudden flare-up in the food prices.

Weighed against this, the impact of the implementation of the Seventh Pay Commission is uncertain, and the global commodity prices especially those of oil are expected to be volatile. In total, the RBI has flagged the several risks to inflation, but has kept its target unchanged. The RBI is positive on economic growth but improvement in the several growth drivers will be gradual. Liquidity conditions will remain benign.

The RBI is, however, concerned that improved liquidity conditions and the rate cuts have not translated into lower market interest rates. In other words, the market transmission remains incomplete and is a big worry. Adequate transmission would ensure a fair deal for all borrowers and will also contribute to transparency.

Emphasise the common man

It is obvious that the purport of the monetary policy announcements is for the markets and institutions with individuals remaining in the background. However, there is plenty for the common man as well. First, the RBI’s clean cheat to macro-economic management is seen as its optimism, albeit subdued, over the economic growth.

The Indian economy is growing faster than other economies of similar size. Yet, there are vulnerabilities arising from both domestic and global factors. Also, the quality of official economic statistics has been questioned by several agencies including by the RBI. Individuals, as much as the markets, would naturally want accurate statistics.

A specific monetary policy concern for individuals lies in the interest rate changes. This was not the case a few decades ago when market interest rates were regimented and there was no worthwhile lending to sectors such as the residential housing.

Today, banks have leeway in quoting differential interest rates on loans structured according to the market needs and to sectors such as housing.

Indeed with liberalisation and deregulation of the financial sector, banks have been pushed into a competitive environment forcing them to adopt measures like computerisation and a much higher level of asset-liability management. The banks may sound esoteric but their focus is always on the individuals. The challenge for the economic policy making, not just monetary policy, is to spread awareness among individuals, about the sweeping changes taking place in the financial sector and by implication the macro-economy.

It would of course help if other arms of the government such as the office of the chief economic adviser to the finance minister step up their efforts at dissemination of such awareness. That would further enhance the credibility of the macro-economic process and contribute to an informed decision making among the public.