Keep it tight, Rajan

In a carefully crafted statement, RBI Governor Raghuram Rajan has set out his vision statement for the bank.

On the conduct of monetary policy, he drew his mandate from the RBI Act of 1934 and said: “The primary role of the central bank, as the Act suggests, is monetary stability, that is, to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation, whether the inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures”. This, in a nutshell, is Rajan’s unequivocal mission statement.

On September 12, Rajan set up a Committee under Deputy Governor Urjit Patel to: (i) review the objectives and conduct of monetary policy in a globalised and highly inter-connected environment, (ii) to recommend an appropriate nominal anchor, (iii) to review the operating framework and (iv) to identify impediments to monetary policy transmission.

For many years, monetary policy was conducted in a closed economy model and external sector problems were dealt with by an intricate web of controls. With the opening up of the external sector, monetary-fiscal weaknesses quickly spilt onto the external sector. The collective unconscious, however, believes in the efficacy of controls.

Nominal Anchor

During the Rangarajan Governorship (1992-97), the RBI came close to setting a nominal anchor. The Real Effective Exchange Rate (REER) was the pole star and there was overt support by the Government and the RBI to monetary targeting, and pre-eminence was given to inflation control.

Subsequently, there was increased emphasis on multiple objectives which resulted in the rejection of the Narasimham Advisory Group (2000) recommendation for a monetary policy mandate with primacy to inflation control.

A nominal GDP anchor would work adversely to the basic intention. For instance, a nominal GDP growth of, say, 15 per cent could be made up of an 8 per cent real growth and a 7 per cent inflation.

Alternatively, it could work towards a 5 per cent real growth and a 10 per cent inflation rate. Thus, a nominal GDP growth would not be an efficient anchor.

To the extent the inflation rate is made the nominal anchor, it would be best to move away from the Wholesale Price Index (WPI) and use the headline Consumer Price Index (CPI) — the standard measure the world over.

The RBI should not shy away from the CPI as the nominal anchor merely because food and fuel are predominant in this index. In fact, this should be the precise reason for using the CPI Index as the nominal anchor.

While the objective should be set out jointly by the Government and the RBI, inflation control should take precedence and the other objectives, if any, should be subordinate to this.

Operating Framework

While reviewing the operating framework, the excellent Mohanty Working Group Report (2011) should be revisited. It would be best to move away from a corridor to a single policy repo rate. While the reverse repo is not of significance at the present time, this facility is akin to giving interest on excess cash balances. This goes against the spirit of the law which does not allow payment of interest on required cash balances. Payment of interest on cash reserve ratio (CRR) balances attenuates the CRR, and the RBI ultimately had to move away from it. This is a mortal sin of central banking. Having redeemed itself the RBI should never again lapse into sinning.

The RBI should not restrict itself to the short end of the yield curve — akin to the US ‘‘Bills only Doctrine’’ of the 1950s.

In a well-functioning system, the long rate should be the average of the future anticipated short rates, adjusted for risk and uncertainty.

As such, an inverted yield curve cannot be sustained over a long period of time (issues relating to monetary policy and internal debt management need separate detailed examination).

Monetary Policy Committee

While a formally constituted MPC would be desirable, the Financial Sector Legislative Reforms Commission (FSLRC) model renders the RBI ineffective. The way the Committee is proposed to be set up, with a predominance of government-appointed external members and veto power for the Governor, is not the best of options. It would be preferable to follow the Bank of England model of five internal members and four external members, but there should be no veto for the Governor.

Given the high current inflation rate and the large CAD, notwithstanding the US Fed decision on September 18 not to taper the quantitative easing, the RBI would do well not to ease monetary policy today. The differential between the yields on US gilts and Indian gilts is insufficient to allow for inflation rate differentials. Any signal today by the RBI of monetary easing could trigger an outflow by foreign investors from the debt market. Hence, it is hoped that Governor Rajan would not reduce policy interest rates or reserve requirements (including the 99 per cent daily requirement for the cash reserve ratio) and not expand refinance facilities. If the RBI eases monetary policy today and the Fed tightens its policy at the next review, the RBI would find the imperatives that much more difficult to tighten monetary policy a few weeks later.

While the Foreign Currency Non-Resident (Banks) Deposit scheme (FCNRB) and overseas borrowings by banks have been given temporary support via RBI swap facilities, this violates our 1994 commitment on current account convertibility and should be withdrawn immediately. Besides, it exposes the RBI to losses of an estimated Rs 60,000 crore which would be self-immolation.

(The author is a Mumbai-based economist.)

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