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Monetary policy and inflation control - Outside View by S.S. TARAPORE

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Monetary policy and inflation control
Nov 5, 2013

Reserve Bank of India (RBI) Governor Raghuram Rajan presented his maiden Quarterly Monetary Policy on October 29, 2013. While industry and media will no doubt bisect and dissect every word of his short policy statement, there are a few issues of concern to the common person.

Forthright recognition of inflation

The policy statement stresses that inflation, measured by the Wholesale Price Index (WPI), rose in September 2013, for the fourth month in succession and the statement candidly says that the overall WPI inflation is expected to remain higher than current levels through most of the remaining part of the year, "warranting an appropriate policy response."

Again, on retail inflation, measured by the Consumer Price Index (CPI), the statement categorically states that retail inflation is likely to remain around, or even above, nine per cent in the months ahead "absent policy action."

The statement recognises that the RBI accommodation to banks can only be a marginal support and going forward, the more durable strategy for mitigating mismatches between supply of and demand for funds, is for banks to step up efforts to mobilise deposits. With the more recent upturn of inflation, inflation expectations remain elevated. The policy statement recognises that it is important to break the spiral of rising price pressures in order to curb erosion of financial savings.

The policy stance and measures are intended to curb mounting inflationary pressures and manage inflation expectations in a situation of weak growth. The RBI would "closely monitor inflation risks while being mindful of the evolving growth dynamics."

The RBI has to undertake a fine tightrope balancing act between its legitimate concern for inflation control and the government's instinctive preference for fostering a revival of growth, particularly in the industrial sector.

Policy measures

The policy measures are, admittedly, difficult for the common person to understand, but it would be useful to explain the measures in simple terms. The RBI provides accommodation to banks under the repo facility i.e. against the collateral of government securities.

As part of the July 2013 measures, the limits were reduced from 1.0 per cent to 0.5 per cent of deposit and other liabilities. When providing accommodation beyond the quota, under the Marginal Standing Facility (MSF), accommodation was provided at one percentage point above the repo rate; as part of the July 2013 measures, this was increased to 3.0 percentage points above the repo rate.

With the easing of the exchange rate pressures, the MSF rate was gradually reduced. In the October 29, 2013 policy, the repo rate has been raised by 0.25 percentage points to 7.75 per cent. Simultaneously, the MSF rate has been reduced from 9.0 per cent to 8.75 per cent. Thus, the margin between the repo rate and the MSF rate has been brought back to 1.0 per cent, as prevailing prior to July 2013.

As regards the limits for RBI accommodation, an additional facility of 7 days' and 14 days' repo, through auctions has been introduced and from October 29, 2013, the limit for such accommodation has been raised from 0.25 per cent of liabilities to 0.5 per cent. The term repo rate would be determined in the auctions between the repo rate and the MSF rate. The intention is to make the repo rate as the policy rate, around which other rates would be determined.

Impact on savers

The impact of the October 29, 2013 policy measures on the remuneration of savers would be marginal, as it is unclear whether banks would raise deposit interest rates. The significant point is that the policy statement emphasises that inflation erodes the rate of return to savers and as there has been a clear trend of reduced household sector savings in financial assets, there is an urgent need for effective measures to stimulate savings.

Retail inflation index securities

The October 29, 2013 policy statement sets out some of the salient features of the proposed retail inflation-indexed securities to be issued in November/December 2013. The security would be linked to the new (combined) CPI. The eligible investors will be individuals, Hindu Undivided Families, trusts and charitable institutions. The rate of interest on these securities would comprise a fixed rate plus inflation. An important feature is that interest would be compounded half-yearly, but paid cumulatively at redemption. There are two concerns. First, with interest being paid cumulatively on redemption, this scheme would not be attractive to senior citizens and others who need interest income to defray their expenditures.

Secondly, how interest is indexed is important. If the fixed rate is, say 3 per cent, and inflation is 10 per cent, the effective nominal interest should be 13 per cent and not 3.3 per cent as per the Indexed Bond issued a few months ago. If the effective nominal rate is very low and interest paid only on redemption, the security would be a total flop and the authorities had best not issue such a security.

Savings bank accounts & cartelization

As banks are now on core banking platforms, in the October 29, 2013 policy, banks have been given the option of paying interest on savings deposits at intervals shorter than quarterly intervals. Savings bank depositors have been unfairly treated by the system. With all the fanfare about financial inclusion, it is pertinent to note that most small depositors in the rural areas essentially maintain savings bank deposit accounts. The RBI should give serious attention to the excellent study by Ashish Das of the Indian Institute of Technology, Bombay, on "Interest of Bank Depositors in Chaos." He recommends that the RBI should make interest application on deposit accounts at monthly or shorter rests (on lending banks use monthly rests). The savings bank deposit rate has been deregulated, but most banks still follow the erstwhile controlled rate of 4 per cent. This smacks of cartelisation, but, for some reason, the RBI does not see it as a case of cartelisation.

The institutional memory of the banking system will recall that many years ago, banks faced questions on cartelisation. The time is apposite for an amicus curiae (friend of the court) to take up the issue with the Competition Commission and or the Courts.

Please Note: This article was first published in The Freepress Journal on November 04, 2013. 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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