A focus for the RBI

Indian Express, 24th September 2013

It needs a well-defined objective and policy instrument.

In his maiden monetary policy announcement, RBI Governor Raghuram Rajan unveiled a mix of easing and tightening measures. He raised the repo rate and lowered the bank rate. In July, the RBI had suddenly raised rates to defend the rupee. Since then, the bank rate, or the MSF rate, has become the operational policy rate, the rate at which commercial banks borrow from the RBI. It is too high for the economy today and needs to be reduced even further.

The decision to cut the MSF rate was obvious. That was the easy part. Rajan also raised the repo rate, which used to be the policy rate before the RBI's actions to defend the rupee in July. This was supposed to indicate the RBI's intent to target inflation by lowering inflationary expectations. Bringing such expectations down is a difficult task for any central bank. For the RBI, the problem is even more difficult since it must balance multiple objectives, has numerous instruments and is not independent.

Rajan will have to work hard to build the RBI's credibility as an inflation targeter. He will need to get rid of its multiple objectives and many instruments. He will have to focus on defining the objective of monetary policy and its instrument clearly, building credibility, being consistent and communicating his policy stance to the public. The success of his term will be measured by how well he is able to anchor inflationary expectations and bring down consumer price inflation. The growth slowdown and high food inflation will make inflation forecasting and targeting difficult. So far, the RBI has not managed to communicate clearly because it has too many instruments and unclear objectives.

In the credit policy announcement, Rajan increased the repo rate under the liquidity adjustment facility (LAF) by 25 basis points, from 7.25 per cent to 7.5 per cent. This was clearly intended only as a signal, since restrictions on borrowing from this window were not reversed. While banks can borrow 2 per cent of their liabilities at the MSF rate, after the RBI's July actions they can borrow only 0.5 per cent of their liabilities under the LAF. The target corridor for the overnight interest rate has the MSF rate on top, the repo rate in between and the reverse-repo rate at the bottom. The narrower this corridor, the clearer the RBI's policy stance is. Today, this corridor is too wide and the interbank rate has been moving beyond it.

Rajan's first task is to make the repo rate the operational policy rate. This means the RBI must stop using other instruments for easing or tightening monetary policy. Today, policy objectives are achieved through 10 instruments: foreign market intervention, open market operations, the repo rate (which will eventually become the only instrument), the reverse repo, the MSF or the bank rate, the CRR, the daily balance of the CRR, the amount that can be borrowed through the repo window, the amount that banks can borrow through the MSF window and the SLR. The RBI often suggests that interest rates (which are the price of money) are not affected by liquidity (the quantity of money in the market). The two, it believes, are somewhat independent of each other and can be manipulated to move in different directions. The origins of this framework go back to the control raj, where for many goods like steel and cement, it was assumed that the prices and quantities in the market moved independently of one another.

The RBI will need to clarify its measure of and numerical target for inflation to anchor expectations. In its most recent policy announcement, the target inflation measure was still unclear. In his press statement, Rajan said a WPI inflation of 5 per cent would be achieved by the operating framework put in place by the Urjit Patel committee. However, in his speech he had said he would focus on CPI inflation. Consequently, confusion about the RBI's measure of inflation remains. Ideally, the objective inflation measure should be in the monetary policy law, or stated by the government, as it is in other countries. The RBI should be made accountable to achieve that target. It is not the job of the central bank to define its own targets. This reduces accountability. It is likely that a change in the law will happen during Rajan's tenure, but maybe not soon enough.

Short-term pressures on the rupee may deflect the focus from a clean and transparent monetary policy framework for inflation targeting, as we saw in recent weeks. One option is to move to a fully floating exchange rate, while undertaking financial sector reforms to increase the capability of the private sector to hedge its exposure. This would give the RBI monetary policy autonomy, even though the capital account, de-facto, remains open. The other option is to interfere in markets, impose capital controls and mount interest rate defences in response to exchange rate movements. The extent to which Rajan will follow this path remains to be seen. This is not the appropriate direction for India to be moving in and he will undoubtedly be mindful of that.

Today, too much depends on the personalities in power. The way ahead is institutional change. The Indian Financial Code, recommended by the Financial Sector Legislative Reforms Commission, will require the government to give the RBI a clear target, to achieve which it will be given independence and made accountable. The enactment of the code will pave the way to making the RBI an inflation-targeting central bank with a well defined objective and policy instrument. Until then, Rajan will likely walk a tightrope and we may see knee-jerk reactions from the RBI, in its trying to achieve too many objectives with too many instruments. The outcome will also depend on the political pressure on the RBI. The next finance minister may not respect Rajan's decisions. Institutionalising the new framework should be his top priority.