The MPC/RBI announcement on rates on May 4 is unique not only because it came from the blue but also because the language and tone were quite different from what one expects. The idea of having a bi-monthly monetary policy is to ensure there is certainty in expectations, where the market players can take a call without there being the ‘noise’ element. The pandemic did definitely cause a deviation as the MPC (Monetary Policy Committee) met any time that was required and policy decisions were taken.

But now that a precedent has been set in normal times, what are the takeaways from this exercise?

The first and the most obvious is that the MPC can meet without prior intimation. Normally, the protocol is that the public gets to know that the members are meeting. But the surprise element here is significant because going by the doctrine of economics under the ‘rational expectations’ banner, which was popularised by Thomas Sargent and Neil Wallace, policy works only if the market is surprised.

There is a lot of truth in this theory. When everyone expects the RBI to increase/decrease rates and the MPC decides accordingly, then it is said that the market has already discounted the action and there is no material difference. In such a case, one says that the policy is not really potent. Surprise can be a new way of making monetary policy more effective.

Accommodative stance

Second, the term ‘being accommodative’ has to be viewed differently when it comes to the stance of the MPC. Earlier, an ‘accommodative stance’ was interpreted as a position where the RBI is there to provide liquidity whenever required. Later it was clarified that such a stance meant that the repo rate will not be increased. But now we have a situation of being ‘accommodative while focusing on withdrawal of accommodation’, which can be a tongue twister. This has been accompanied by increasing both the repo rate as well as the CRR.

Therefore, the conventional way of looking at monetary policy stance has changed and the market has to guess every time what accommodative stance means. Interestingly, a question can be asked as to what would then be the ingredients of a neutral stance.

Third, inflation targeting may not be the only variable besides GDP for the MPC. It may be recollected that the MPC had the mandate of targeting CPI inflation at 4 per cent with a band of 2 per cent on both sides. But once the pandemic set, central banks across the world pledged to do everything that was required to stabilise growth which meant following ultra-easy monetary policy. This focus on growth has so far held the RBI back from addressing inflation.

In the April policy, the RBI did highlight the threat of inflation but left the rates unchanged. Interestingly, nothing much has changed since then and hence the sudden convening of the MPC can be attributed to the fact that there is concern on the external front, too, where FPIs have been negative and there is relentless pressure on the rupee.

Currency management

With the Fed planning rate hikes, it does appear that currency management has also entered the consideration of the RBI/MPC. This makes sense as repo rate hike narrows down the interest rate differential with, say, the Fed’s anchor rate. But will this then mean that every time the Fed keeps increasing rates, we will have to follow the same path?

Fourth, conventionally, the RBI has been changing the repo rate by 25 basis points (bps) at a time. In 2019, there was an experiment with 35 bps from 5.75 per cent to 5.40 per cent while in 2020 the pitch was for 40 bps to bring it down to 4 per cent from 4.4 per cent. Therefore going ahead, the changes in repo rate need not be in multiples of 25 bps and an odd 35 bps cannot be ruled out at some stage. This can be a surprise element for the market.

Fifth, the CRR, though reduced by 100 bps during the pandemic, has been virtually moribund for a long time. But the use of CRR now to withdraw liquidity of ₹87,000 crore is interesting as this is a permanent removal of liquidity from the system. The amount of surplus liquidity in the system has been ₹5-7 lakh crore for more than a year now and the market has been guessing for long as to how this amount will be withdrawn from the system.

The signal sent is that while OMOs (open market operations) are there and there could be sale of securities at some point of time, the RBI would also use the CRR to impound funds. Therefore, there can further rounds of CRR hike. For banks this is not good news because OMOs would have meant holding securities which gave a return of 6.5-7.5 per cent, while this permanent withdrawal of liquidity means a monetary loss for banks, because even if kept in SDF for a year they would yield around ₹3,600 crore. There is hence an opportunity cost involved.

Sixth, the timing of the policy on the day of the LIC IPO is also interesting. It would have been known that the stock market would fall once the repo rate was hiked. But this has not deterred the MPC from taking a call on rates, as probably timing it before the Fed announcement took precedence over stock market considerations. This independent view is significant because clearly the MPC is looking closely at fulfilling its objectives of working to tame inflation.

It must also be remembered that the RBI also is the banker to the government and hence has to manage the cost of debt. This has been one reason why the central bank has to also work to keep interest rates down. But now with the repo rate being increased, the Centre and States will have to pay more for their debt.

This announcement may just be the beginning of another variety of monetary policy presentation in terms of timing and content. Should markets be ready for more surprises?

The writer is Chief Economist, Bank of Baroda, and author of ‘Lockdown or Economic Destruction’. Views are personal

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