Context
Communication is a critical element of monetary policy. Yet there seems to be a gap between what the MPC says and what the RBI does.
About MPC
- The Reserve Bank of India Act, 1934 (RBI Act) has been amended by the Finance Act, 2016, to provide for a statutory and institutionalised framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth.
- Highest monetary policy-making body: By law, the Monetary Policy Committee is the highest monetary policy-making body in the land, tasked with deciding monetary policy changes at regular intervals.
- Composition: The MPC will have six members – the RBI Governor (Chairperson), the RBI Deputy Governor in charge of monetary policy, one official nominated by the RBI Board and the remaining three members would represent the Government of India.
- The MPC will be chaired by the Governor.
- Under the inflation targeting regime, the most important role in communication belongs to the MPC.
Communication with public
- Monetary policy changes are communicated through formal statements, with the discussions underlying these decisions also being published, so that the public can understand why the MPC decided the way that they did.
- Communication gap: Over the past few years, a communication gap seems to have opened up between what the MPC has been saying and what the RBI has been doing, thereby potentially eroding the credibility of the IT framework.
- Influencing inflation expectations: Communication is an important part of the ability of the central bank to influence inflation expectations.
Following are the ways which indicate the communication gap between the RBI and the MPC, with several implications for the credibility of the MPC.
1] Separate statements
- During the first few years of the inflation-targeting regime from 2016 to 2018, the process of communication worked quite well.
- On the days of policy announcements, the governor and his deputies would participate in a press conference.
- From 2019 onwards, however, things began to change.
- Governor’s separate statement: The RBI began to release a separate governor’s statement on the day of the monetary policy meeting, presenting an inflation outlook and even explaining the decision taken by the MPC.
- MPC statement: It has overlapped with the MPC statement; at times, it has seemed somewhat different.
- For example, following the June 8 Monetary Policy Review the MPC highlighted inflation concerns, and voted in favour of raising the policy repo rate.
- On the same day, a governor’s statement mentioned that the central bank will also remain focussed on the orderly completion of the government’s borrowing programme.
- Confusion: The issuance of two such different statements can lead to confusion, especially as lowering inflation and lowering government bond yields are contradictory policy objectives.
Why is communication so crucial? To influence inflation expectations!
- If the public believes the central bank is committed to keeping inflation under control, then it will act accordingly.
- Firms will moderate their price increases, fearing that large price rises will make them uncompetitive.
- Meanwhile, workers will accept moderate wage increases, while investors will accept low interest rates on their bond purchases.
- With everyone acting in this way, it will be easier for the central bank to ensure that inflation indeed remains low.
- Anchored inflation expectations: If inflation expectations are well anchored, then it becomes relatively easy for the central bank to ensure that inflation returns to the target level before too long.
2] Change in the Monetary Policy Corridor width during pandemic
- Deciding the repo rate: The most important task of the MPC, enshrined in the RBI Act (Amended), 2016 that introduced IT, is to decide the repo rate, since this has long been the lynchpin of India’s monetary policy framework.
- Ever since the early 2000s, policy had aimed to keep overnight money market rates in a corridor, with the lower bound established by the reverse repo rate and the upper bound by the repo rate.
- Since the width of this corridor was fixed, once the repo rate was decided, the reverse repo rate was automatically determined, and market overnight rates adjusted accordingly.
- During the Covid-19 pandemic, the RBI constantly adjusted the reverse repo rate even as the MPC kept the repo rate unchanged.
- As a result, the fixed width of the corridor was lost, and the MPC lost any role in determining interest rates.
3] Introduction of policy instruments outside the remit of MPC
- During pandemic, the RBI introduced a number of new policy instruments, again outside the remit of the MPC.
- GSAP: It brought in the GSAP programme through which it pre-commited to buying a certain amount of dated government bonds in order to control their yields.
- Variable reverse repo auctions: It then introduced variable reverse repo auctions, and more recently, replaced the reverse repo rate with the long-dormant standing deposit facility rate.
- The rationale for this was not explained in the MPC statement.
- All unconventional monetary policy announcements were kept outside the MPC statement.
- This raised the questions about the role of the committee in deciding monetary policy actions at a crucial time like the pandemic.
4] Intervention in the foreign exchange market
- The RBI has been intervening in the foreign exchange market to manage the rupee.
- Forex interventions by definition influence the domestic monetary base and inflation.
- Yet the MPC in its monetary policy statements does not discuss either the exchange rate dynamics or the forex interventions.
- Just as it does not discuss the RBI’s interventions in the bond market to lower the yields.
Way forward
- In its latest two statements, the MPC indicated that policy would now be focusing on bringing India’s inflation rate under control.
- Clear policy framework: If the RBI is going to be successful in this endeavour, the first step must be to close the communication gap, by reintroducing a simple and clear policy framework and restoring the central role of the MPC.
Conclusion
The net result of all these actions is a potential loss of both clarity and credibility. The communication gap will need to be closed in order for the RBI to become successful in bringing inflation back to its 4 per cent target level.
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Back2Basics: Monetary Policy Corridor
- The Corridor in the monetary policy of the RBI refers to the area between the reverse repo rate and the MSF rate.
- Reverse repo rate will be the lowest of the policy rates whereas Marginal Standing Facility is something like an upper ceiling with a higher rate than the repo rate.
- The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.
- As per the monetary policy of the RBI, ideally, the call rate should travel within the corridor showing a comfortable liquidity situation in the financial system and economy.
What is GSAP?
- The G-Sec Acquisition Programme (G-SAP) is basically an unconditional and a structured Open Market Operation (OMO), of a much larger scale and size.
- G-SAP is an OMO with a ‘distinct character’.
- The word ‘unconditional’ here connotes that RBI has committed upfront that it will buy G-Secs irrespective of the market sentiment.
