RBI's Economy Assessment Doesn't Tell Us Why Holding Rates is the Best Option

Perhaps the biggest casualty of demonetisation has been the central bank's loss of autonomy as it has allowed the government to ride roughshod over it.

Reserve Bank of India Governor Urjit Patel with former governor Raghuram Rajan in the background. Credit: Reuters/Danish Siddiqui

Reserve Bank of India Governor Urjit Patel with former governor Raghuram Rajan in the background. Credit: Reuters/Danish Siddiqui

The Monetary Policy Committee (MPC) of the Reserve Bank of India sprang a big surprise when it unveiled its fifth bi-monthly review for the current year on December 7. The statement, only the second with the new governor Urjit Patel in charge, incorporated the resolution of the MPC, which itself is just two policies old. That the new arrangement will remain under lens for quite some time is obvious. But to single out the new arrangement and its members for harsh criticism by attributing the central bank’s handling of contentious issues (such as demonetisation) to the MPC is unwarranted .

The committee’s unanimous decision to keep the policy repo rates unchanged at 6.25 percent is the big surprise. An overwhelmingly large number of market participants who were interviewed by a leading business channel voted for a 0.25 percentage points reduction, with a smaller number favouring a 0.50 percentage point cut. Very few thought that the RBI would maintain the status quo.

It is true that springing a surprise on a volatile equity or forex market is an accepted strategy and has been used by previous governors with telling effect. But in all those cases, the RBI was able to explain its rationale even as it could quantify the expected  positive results. Neither of these is evident this time. The RBI’s assessment of the economy both domestic and global does not indicate why holding rates is the preferred option. Nor will the inaction on the rate front achieve anything tangible in the face of the turmoil unleashed by the demonetisation of specified bank notes (SPNs)

Indeed, demonetisation and its fallout over the last month do not reflect well on the RBI. It could have applied brakes on an overbearing government by pointing out that there were not enough new notes to replace old ones. The banking system has been subject to a bewildering variety of complex rules and regulations to cope with demonetisation. Besides, communication, so vital from the RBI, has been singularly lacking. Perhaps the biggest casualty has been the central bank’s loss of autonomy as it has allowed the government to ride roughshod over it.

Depositor interest

Is the latest policy statement a way of hinting at better things to come? One has to wait and see.

The MPC  maintains headline consumer price inflation for March 2017 at 5% but has lowered the growth forecast GVA estimate for the end of the year (March 2017) down by 0.5 percentage points to 7.1 percent mainly due to the lower growth in the  second quarter (June -September 2016.). There are however upside risks to the inflation estimate.

Factors that have weighed with the MPC are varied and include domestic as well as global factors. Demonetisation has had a major impact throughout India, although its full effects are still a matter of conjecture.What is clear however is that it has inflicted all-round pain which policy makers think can be contained within the short term. Matters concerning demonetisation are inevitably clouded in politics.

Turning to specifics, the surge in bank deposits after the demonetisation drive is seen as transitory. RBI has given greater elbow room to banks to use the Market Stabilisation Scheme (MSS). Also, the increase in CRR has been withdrawn. These two would be welcomed by banks who are groaning under the burden of a surge in inflows. Deposit rates are falling and bank lending rates are set to follow. In all this, the bank depositor who has nowhere to go suffers. It is hoped that future monetary policy statements will take cognisance of depositor’s ïnterests as well.

To sum up, nobody can fault the committee’s assessment and its summing up of our current situation. The bi-monthly review is set against the backdrop of heightened uncertainty. The imminent tightening of monetary policy in the US is triggering bouts of high volatility in financial markets. In India, supply disruptions in the backwash of currency replacement may drag down growth.

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