The June monetary policy was indeed extraordinary. The growth supporting activism that began in February seems to have ended with an unusual big bazooka action that conservative central bankers ordinarily reserve for shocks like the global financial crisis or the pandemic. What the RBI delivered was a monetary policy surprise accompanied by reduced monetary policy uncertainty.
The surprise was twin packed — a 50-bps policy rate cut with a front-loaded announcement of a back-loaded 100 bps reduction in CRR — but it came with a change in stance from accommodative to neutral in a bid to reduce monetary policy uncertainty ahead. The Monetary Policy Committee (MPC) transparently explained this move by stating that it is now left with very limited space to support growth.
Perverse market response
Sadly, transparency has its limits. Financial markets loved the monetary surprise but not the reduced monetary policy uncertainty through the stance change. As a result of the stance change, transmission at the short-end of the yield curve was squelched. TREPS (Treasury Bills Repurchase) which ordinarily should have fallen by 50 basis points (bps) declined by 37 bps given the uncertainty about where the RBI wants short-end to be anchored. The 364-day T-bill yield dropped by 16 bps.
The belly of the yield curve of 5-7 year segment from which banks price their products the most hardened 1-3 bps, while the 10-year benchmark securities old as well as new which also have significant impact on lending in fact edged up by 4 bps and the 30-year bond hardened by 8 bps. Financial markets are forward-looking and when they see no further rate cuts coming, they have no-appetite left for bonds and they may only book losses on holding such portfolio. Consequently, the yield curve steepened. Five-year OIS (Overnight Index Swap) also firmed up.
If this trend is not corrected through subsequent financial market operations such as Operation Twist, it could considerably erode intended outcome. In this case, monetary space could get squandered with less arsenal left in armoury.
The great monetary experiment
On the other hand, if it does succeed in shoring aggregate demand and lifting this year’s growth from projected 6.5 per cent (with current low WPI inflation, the deflator benefit may take it to 6.7 per cent) to around 7.5 per cent in a non-inflationary manner, the great risky experiment of this policy action will prompt a rethink in conservative central bankers.
Monetary transmission operates with long and variable lags and the central bank had missed the turning point of the business cycle both in its last tightening and last easing monetary policy cycle.
Now, RBI sensed and seized the opportunity afforded by headline inflation being markedly below the 4 per cent inflation target. Last October, similar opportunity arose before the previous MPC, but it chose patience over valour in a bid to smooth out interest rate movement that left it behind the curve.
It has now caught the turning point of the business cycle; but has it also got the quantum of action and its communication, right? Does the big bazooka it now used carries any ‘back blast’ risks or are we confident it will not recoil? The answer will lie in what it does to growth. It looks it is not just a countercyclical measure but is packaged with a new regulatory outlook and thinking about re-fixing CRR as a mix of monetary, liquidity and regulatory tool to affect structural growth.
Despite the capacity utilisation rates hovering marginally above its long-term average for the last 12-quarters, big-ticket corporate investments have not been kicked off and lower hurdle rates are unlikely to do so. The monetary bazooka can only provide transitory small benefits of some increase in mortgage lending.
Paradoxical questions
The judgment on the quantum of action will get tested as we go down the timeline. A few questions do arise in one’s mind.
First, if growth projections haven’t changed since April policy the only two reasons for such strong monetary action can be: (1) larger than anticipated decline in near term inflation that gives central bank elbow room to act under the inflation targeting framework; (2) a decline in uncertainties that may be holding action from the central bank.
April policy was framed on the back of Liberation-Day tariffs. Since then, “TACO trades” have given added confidence that markets are withstanding the rolled back Trump tariffs. But have global uncertainties died so much as to give RBI confidence to use nearly all its left-out ammunition in one go? Are we done with geopolitical uncertainties in Ukraine, Middle East and in our own sub-continent?
More importantly, the near-term inflation decline does not appear durable if one was to go by RBI’s average Q4 inflation projection of 4.4 per cent. Since these projections do not factor the action in this policy, it means that inflation projections should be north of 4.5 per cent by the year-end. This then raises the question if such a front-loaded action was the best course. Difficult to pass a firm judgment and only time will tell if moving away from conservative central banking was the right course.
Neutral stance with accommodation
Second, how do we interpret a change in stance over two consecutive policies? To my mind it is not an issue so long as forward guidance is not misleading. This will get tested in August when inflation prints might even test sub-3 per cent mark in absence of weather disruptions raising clarion calls for another rate cut. To get this clear, it is important to understand that with a neutral rate of 1.65 per cent (mid-point of the RBI range of 1.4 per cent-1.9 per cent), a policy rate of 5.5 per cent which one expects now to be held unchanged for at least till the December policy would mean a real policy rate of 1.1 per cent if Q4 inflation projection is subtracted from the policy rate.
This means monetary policy is being kept quite accommodative notwithstanding the change in stance to neutral. The RBI’s interpretation of stance seems to be a forward guidance that it can change policy rate in any direction should it need to do so, rather than an indication whether it wants interest rates to be accommodative, neutral or tight.
The risks have gone up
At this juncture, it does not appear to be a grave problem as real lending rates have softened but remain in positive terrain. However, if inflation rises, it can bring savings under pressure as the net household financial saving rate has already dropped to around 5 per cent of GDP for the last two years and flow of household liabilities are already above 6 per cent of GDP. So, RBI should be prepared to act in either direction if conditions change and warrant some tightening. Neutral stance affords that option.
Third, on liquidity too, the RBI seems to be choosing to flush the markets. System durable liquidity had already moved up from ₹1.3 lakh crore at the time of April policy to ₹3.5 lakh crore at the time of June policy decision. Government spending will rise on back of RBI surplus transfer bonanza. It might have been better to take CRR action in August after a better grip on liquidity requirements in those near months to better time unwinding of the forward positions.
The front-loaded action now has increased risks in the system by cringing on future policy options. While central banks do give forward guidance which now are part of unconventional monetary policy toolkit, they are rather used sparingly to deal with sudden large shocks. It is hardly the job of the central bank to commit forward monetary policy actions that go beyond forward guidance.
The writer is currently Professor at IIM Kozhikode and formerly RBI Executive Director and MPC member. The views are personal