In the week of central bankers, the Federal Reserve has surprised by holding back a widely expected cut in the monthly bond purchase programme. RBI is also widely expected to largely hold the main components of the monetary policy instruments, at best tweaking some parameters of the tightened framework it had put in place over the past couple of months. This perception is based on the match between objectives and instruments, the economic tradeoffs involved in the use of alternative combinations of instruments and the transmission channels for the chosen instruments to achieve the desired objectives.
In this complicated economic environment reminiscent of the impossible trilemma?currency volatility with persisting inflation and attempts to increase capital inflows?matching objectives to the available policy instruments is likely to be the key choice for the policy decision. Three principal objectives are price, currency and financial stability, with the first being primus inter pares. Price stability is the central objective of any central banker, whether operating with an inflation targeting mandate or a more general one including fostering growth and employment. If inflation expectations become unhinged, the potential of degeneration into a wage price spiral is a central bank?s worst nightmare. In an environment where most markets operate with a great deal of flexibility, a nominal anchor for monetary policy is one of the key decisions. In simple English, inflation expectations must be controlled.
The tradeoffs in balancing the objectives are well known. The growth-inflation tradeoff is normally the centerpiece. The fulcrum of a meaningful discussion of the tradeoff is a fix of the deviation of actual activity from ?potential? output. If output has dropped relative to continuing high growth potential, there is a strong case for monetary easing, since adequate capacity presumably exists to buffer the consequent increase in demand. Otherwise, any demand increase will quickly lead to an inflationary surge. India?s potential output level is unfortunately not very well understood, and is an impediment to calibrating policy change, and even direction. A key question here are the mechanisms which permit continuing high CPI retail inflation even when there are ample signs of demand destruction. An interest rate defence of the currency is likely to have collateral damage on growth and thereby the fisc and the banking sector, prompting the next decision on whether to persist with the tight liquidity policy or letting the Rupee find its market level, albeit in an orderly manner. Unfortunately or otherwise, the Federal Reserve has chosen to push back its tapering programme. While this is great for India in the short term, uncertainty on timing will continue to linger, inducing episodes of volatility, which will make the ongoing transition in India more tricky.
The third aspect is the mix of instruments that the central bank has to address?individually and jointly ? the objectives. The broadest instrument is the policy signal LAF repo rate, upon which is anchored the entire yield curve. Then there are liquidity measures?CRR, OMOs, Cash Management Bills, which have an immediate effect in adjusting liquidity. Then there are operating procedures which finesse the main policy levers, like the MSF corridor, fortnightly average balances for CRR maintenance, LAF limits, etc., which are used in concert with liquidity and rates to tighten response impulses. Macro prudential measures like risk weights, provision cover ratios, Loan to Value ratios, etc., which are used for targeted interventions in specific markets or business segments. Finally administrative measures like closing certain market segments
Managing expectations remains key for effective transmission of policy intent, if not stakeholder response. In the fight against inflation, managing and anchoring expectations remains a key objective. But whose expectations? A segment which can action on this. A survey using households, while replicating actual trends and being a constituent of negotiations, might not be very relevant in transmitting to outcomes. On the other hand, expectations of producers are critical. In wage negotiations, for instance, if manufacturers deem an inability to pass through wage cost increases, they would be reluctant to agree to wage increases in the first place. Recent data on corporate financials indicate just such a weakness. Disparity in PMI readings on input and output prices also reinforces this divide.
Communication is at the heart of managing markets, probably the most effective channel for transmission. Confusion regarding intent and action might lead to unintended consequences, both direct and indirect, as the recent intervention in currency markets demonstrated. This has an immediate implication for policy response. There have been suggestions on transitioning the current tight liquidity stance using an increase in the repo rate while easing liquidity to get overnight rates down to the higher policy rates. Unfortunately, such a strategy will be adverse for markets, signaling reversion to policy tightening, with a consequent tightening of yields across the curve, affecting a range of investors and borrowers. The most effective response now just might be the most straightforward: gradually lower the MSF rate, using supporting liquidity infusion. Although a simplification, this will also address the emerging diverging wedge between credit and deposit growth; if this trend were to continue, liquidity problems will gradually get more aggravated, pushing up short term rates higher than warranted.
The emergence of a credible nominal anchor will almost certainly gravitate towards an inflation measure. However, the role of drivers of inflation needs to be interpreted with care. Ultimately, the effectiveness of monetary policy levers depends on the extent to which multiple risks are mitigated by appropriately allocating them to specific economic groups. Laying off too heavily a risk emerging in one segment onto another which does not have control will inevitably create stress and skew the outcome away from intended.
The author is senior vice-president and chief economist, Axis Bank. Views are personal
