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Towards a better monetary policy - Outside View by S.S. TARAPORE
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Towards a better monetary policy
Jul 28, 2014

With the Union Budget out of the way, media focus will now be on the Reserve Bank of India's Third Bi-monthly Monetary Policy for 2014-15. The budget does give an assurance of working towards a medium-term fiscal consolidation. The fears of a severe monsoon failure have somewhat receded. Industrial output has shown some uptick, though how enduring it would be remains to be seen. The year-on-year inflation rate for June 2014, based on the Consumer Price Index (CPI), shows a deceleration to 7.3 per cent, while the Wholesale Price Index (WPI) is at 5.4 per cent. In India, there are always strong pressures to advocate an easing of monetary policy. In India, there is substantial backing for the view that if only the RBI were to ease monetary policy, particularly interest rates, growth would revive. Unfortunately, formulating monetary policy is not that simple and attention needs to be focused on the downside risk of premature easing of policy.

Global outlook

Among the emerging markets, India still has the highest inflation rate. Moreover, there is a strong possibility of a hike in interest rates in industrial countries, particularly in the US, combined with a curtailment of liquidity. This would impinge adversely on capital inflows into emerging markets. The conflict in West Asia could adversely affect the petroleum sector, which would only compound our difficulties.

Domestic situation

Although the finance minister has emphasised the need for correction of the fiscal deficit, there is little room at this stage for monetary easing. The gross borrowing of the government is a staggering Rs 6,00,000 crore, which would crowd out commercial credit. While the intent of policy is to remove constraints which adversely affect market sentiment, it is not clear as to how the full year will eventually unfold.

Refining framework of monetary policy

The budget speech does well to underscore the imperative need to bring about a significant improvement in the formulation and execution of monetary policy.

The increased focus on the Consumer Price Index (CPI) as the appropriate indicator of inflation is welcome. There is, at the present time, focus on the year-on-year CPI inflation rate. There is a need for further refinement of this indicator. The difficulty of the year-on-year inflation rate as the nominal anchor is that there can be significant variations from month to month. It is essential that the policy rate should reflect a small positive real rate of interest, say 3 per cent. On that criteria, the present policy rate, centred on a repo rate of eight per cent, with CPI inflation at 7.3 per cent, would appear to be less than optimal. It is not feasible to undertake significant changes in the repo rate based on a month-to-month CPI Index. Hence, it is necessary to have a reasonably stable nominal anchor.

Alternative nominal inflation anchors

Monthly data for the new CPI Index is now available for about two-and-a-half years. In this context, a number of alternative calculations could be considered.

First, a twelve-month moving average could be used as a nominal anchor, which can be the basis for deciding whether a policy rate change is warranted. The judgment would no doubt be based on taking into account a number of other parameters.

Second, an average of the monthly data for the past 30 months could be used initially and then a 36-month moving average could be the nominal anchor.

Third, there could be a weighted moving average for five half-yearly point-to-point observations, with a distributed lag with weights of 5, 4, 3, 2 and 1, so that the highest weight is given to the latest data and the most distant observation could have the lowest weight.

These are mere illustrations and RBI technicians could develop a more sophisticated formulation to assess the trend line. The important point is that the formulation should be transparent and easily comprehended by all economic agents.

The advantage of such a formulation would be that policy interest rate changes will not be jerky.

It is essential to get away from the asymmetry of a strong clamour for policy rate reductions but strong resistance to policy rate increases. Under such a system, it would be possible to have well calibrated discrete changes in policy interest rates. As Rakesh Mohan, India's Executive Director on the IMF Board recently said "With inflation raging at 7-10 per cent lending rates cannot be less than 12-14 per cent."

Reserve requirements

Policy interest rate movements will need to be sharper if the monetary transmission process is exclusively dependent on policy interest rates. At least for some time in the foreseeable future, it would be necessary to also use reserve requirements as an instrument of monetary policy.

August 5, 2014 monetary policy stance

For the August 5, 2014 policy review, it would be desirable to opt for a standstill policy on interest rates. The gradual shift to the term repo facility should continue.

The export credit refinance (ECR) facility should be reduced from 32 per cent to 16 per cent of eligible export credit outstanding, with a pro tanto increase in the term repo facility. The overall liquidity has been enhanced by accruals to the forex reserves, which calls for some reduction in overall primary money injection by the RBI

Please Note: This article was first published in The Freepress Journal on July 28, 2014. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.


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