Monetary Policy Tweak: Why The RBI Needs A Real Rate Framework

India’s inflation-targeting framework mandates the Reserve Bank of India (RBI) to have a two to six per cent range, with growth as a secondary and ambiguous target, and any sustained deviations in inflation beyond the above range requiring explanations.

Unfortunately, the Monetary Policy Committee (MPC), which decides the rates has de facto chosen four per cent — it seems — as the ceiling and not the mid-point. For all the months of the past year and more, our consumer price index (CPI) growth has not crossed four per cent year-on-year but has undershot two per cent once.

Earlier, the MPC focused on “core” inflation and inflation expectations, future estimates of inflation etc., as and when convenient. Growth was ignored, while “evergreening” of bad debts was, in a beyond-the-mandate and convenient manner, presented as a risk if rates were cut even when inflation was within the range.

Critics had questioned the rationale behind India moving into an inflation-targeting regime under Modi’s first term at a time when central bankers had started moving away from the same.

But some of us thought, and still think, it is a great move insofar as it anchors the rupee, reduces classic friction costs associated with double digit or higher inflation, and reduces “spreads” in terms of basis points, if not in percentage terms over and above the risk-free rate.

Think of Volcker taming inflation before the near-four-decade bull market in American bonds and equities began — even though there were other factors such as demographics, regulations and taxes.

However, inflation targeting should not mean an anchor-free carte blanche for the RBI. Some focus on what sort of inflation-adjusted, risk-free rates to aim at, while keeping in mind the growth potential of the country (structural and cyclical), is absolutely necessary.

New Zealand, for instance, has amended its monetary policy framework in 2018 and added additional objectives such as employment and financial system stability. Very likely, and sooner rather than later, we may witness more countries move away from any purely unidimensional approach towards monetary policy.

This shift originated largely because of the post-2008 criticism of sole focus of monetary policy on inflation-targeting rather than growth or macroprudential safety.

Therefore, it is surprising that India adopted a very plain-vanilla inflation-targeting framework in 2015 when there was an ongoing debate regarding moving to a broader objective function for our central bankers.

Many have hailed the low levels of inflation experienced in India as proof of the efficacy of the inflation-targeting regime. Yes, but some ignored the fact that India’s CPI has food and fuel as major components in its basket — around half of it.

Therefore, what happens to commodity prices has a disproportionate impact on India’s inflation. A case in point is the UPA years where we witnessed an unsustainable increase in minimum support prices (MSPs), which induced double-digit inflation.

To expect the monetary policy to have a direct impact on food inflation would be to expect an anthropologist to perform a liposuction surgery! (By the way, that would be terribly unfair to our generalist civil servants, who can do both surgery and anthropology.)

But what has our Monetary Policy Framework achieved? One of the highest real interest rates in the world!

Macro 101 asks us to always look at real variables — at least also the real or inflation-adjusted variables. In India, when it comes to monetary policy, the focus is almost always exclusively on nominal repo rates and not real ones.

A consequence of this is that in 2018 we saw the MPC increase interest rates twice — this at a time when inflation was within the inflation range and growth seemed to be lower.

Even when the price of oil fell and the dollar weakened vis-a-vis the rupee in October and November 2018, the MPC did not do anything in December 2018.

There’s a need to revise the monetary framework and give the MPC a ‘soft’ dual mandate of inflation and growth targets — even if inflation-targeting retains some primacy.

The government can explicitly update the framework giving itself the power to adjust the weights from time to time though not very frequently. The framework is up for renewal periodically and while the four per cent median is a good anchor, we need some Taylor-rule-type framework around real rates.

Say, one per cent is the real rate to target (assume repo minus inflation) when growth is sustainable (say, seven per cent in real terms) then we should ideally aim for lower real rates when growth is cyclically lower and higher real rates when it is peaking.

Of course, when inflation is high, the real rate would be higher and vice versa.

The 'neutral' real rates itself could be allowed to be within a certain preferred rate range. We do not need an exact formula here — but just declaring the real rates range (say 0 to 200 bps) properly defined could be a very useful starting point.

For example, right now the real rate is 540 basis points (bps) minus 321 bps or around 220 bps! RBI had once spoken of a neutral rate of around 125-150 basis points — well then, we are at least 70 bps above that while we have record low real growth rates.

Clearly, there is a problem here requiring urgent attention. Yes, just risk-free rates are not enough — we need rationalisation on everything from small savings deposit rates to our financial intermediation more generally to improve transmission (which should in any case not be an excuse to forget about real rates).

However, a slight but smart tweak to our monetary policy will make it more effective as well as accountable. It will also help us think better about our forecasting errors when it comes to either inflation or output gap.

It is worth noting that the MPC has consistently overestimated inflation. A partial consequence of this is the current slowdown of our growth rates (which has other reasons as well), but to simplify a bit for now: it is indeed the interest rates that are the cause for this!