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Monetary policy: More questions than answers

Rajeev Malik
Last week, India’s MPC cut the repo rate for the fourth consecutive time since the seasoned and effective bureaucrat Shaktikanta Das took over as Governor in December 2018. (Illustration: rohnit phore)

An unwritten rule of policy making is that it shouldn't try to solve one problem by creating a new one. Unfortunately, India's monetary policy committee (MPC) conveniently ignored this practical wisdom last week, when it unexpectedly announced an odd-sized cut in the policy repo rate. In one inadequately substantiated step, the MPC has compromised the long-standing discipline that both Indian and foreign investors had come to rely on about the normal binary—mostly 25bp, occasionally 50bp—outcome of policy rate changes. The latest policy action offers no lasting meaningful positive, but increases the uncertainty around expectations of the size of rate changes at future MPC meetings. Further, there continue to be several unanswered questions about the mechanics of decision-making of the six-member panel, its forecasting prowess, and the effectiveness of its communication to better understand its policy response function.

Last week, India’s MPC cut the repo rate for the fourth consecutive time since the seasoned and effective bureaucrat Shaktikanta Das took over as Governor in December 2018. The MPC had eased by 25bp in February, April and June (it also revised the monetary stance to accomodative from neutral at this meeting). The latest cut was a peculiar 35bp, bringing the repo rate to 5.4%. Four members favoured the size of the cut, while the remaining two (both external) members advocated a conventional 25bp move. The cumulative reduction in the repo rate now stands at 110bp.

The strangeness of the MPC's maiden 35bp rate cut is highlighted both by the Reserve Bank of India's (RBI) history of policy rate changes and by the actions of two other central banks that eased on the same day as the RBI. That RBI has not had to resort to such a strange quantum of rate change in the last several years despite experiencing different economic cycles and pressure points, including the sting from the global financial crisis that erupted in 2008, speaks volumes about the sudden shift in the thought-leadership behind the latest policy decision.

Thailand and New Zealand also cut policy rates the same day as India. Thailand eased by 25bp while New Zealand surprised with a 50bp cut. These MPCs are not less capable than our own, but they chose to stick to the long established, clearly understood, and and globally followed approach of changing the policy rate in steps of 25bp. They did not attempt to fix what isn’t broken.

In Asia, China and Taiwan don’t follow this approach, but neither is a role model for modern monetary policy framework. China doesn’t even have advance announcement of its monetary policy meeting schedule. Should the RBI abandon that as well?

While Das has said that there is nothing sacred about 25bp adjustments, his/MPC’s justification for 35bp is woefully inadequate. Simply put, a 25bp cut was too little while 50bp would have been to much. But how did the four wise men who voted for a 35bp rate cut decide on it, and not on 30bp or 40bp? Perhaps it was a pleasant coincidence that all four arrived at that number independently.

Or, perhaps they were convinced by the main proponent for a 35bp rate cut? Earlier this year, Das, in a speech in Washington, had floated scenarios justifying rate adjustments of 10bp (instead of 25bp) or 35bp (instead of 50bp). He had said, “In a situation in which the central bank prefers to be accommodative but not overly so, it could announce a cut in the policy rate by 35 basis points if it has judged that the standard 25 basis points is too little, but its multiple, i.e., 50 basis points is too much.”

It isn’t clear why, given the inflation outlook and the slump in growth (RBI’s forecasting record for both leaves a lot to be desired), the MPC wants to be accomodative but not overly so. Frankly, its incrementalism is part of the problem, not part of the solution. It was slow off the mark in easing and has subsequently revised rates in a gingerly manner.

Almost all other central banks, including the RBI before last week, have stuck with rate adjustments that are 25bp or its multiples, and complemented the rate action with effective communication. Admittedly, the size of the adjustment in recent years in a few advanced countries has been smaller than 25bp, mainly because of their exceptionally low level of policy rates. India, however, doesn’t have the same constraints.

At the June meeting, the MPC members were unanimous in shifting to an accomodative stance and easing by 25bp, though Prof Ravindra Dholakia, reportedly the most dovish member, mentioned in the minutes of that meeting that he would have preferred to cut it by 40bp. The minutes actually don’t hint that a 35bp rate cut was even discussed. It is unclear if that was because adequate votes were not in hand at the time, but the balance changed last week. Recall that Deputy Governor Viral Acharya unexpectedly resigned in late June. Additionally, it is reasonable to ask why Dholakia voted for 25bp at that meeting compared with the 40bp he preferred, despite understandably being concerned about high real rates and correctly recommending a quicker reduction in them.

In an interview prior to last week’s MPC meeting, Das stated that the MPC’s change to an “accommodative” stance in June was equivalent to a 25bp cut in the repo rate. How did he reach that conclusion and how is he so sure the impact wasn’t less than 25bp? Was it a commnuication gaffe, or just convenience of following convention and ease of explaining the essence of his point that the change in stance contributed additionally to the quantum of easing via rate cuts?

RBI remains unduly optimistic in its growth outlook, despite the glacial pace of inadequate revisions to its growth forecast in recent meetings. In the post-policy Q&A with the media, Das stated in response to a query that their “… understanding is that at this point, it is perhaps a cyclical slowdown, not really a deep structural slowdown.” The choice and location of “deep” perhaps gives away the mindset. After all, the question wasn’t between a cyclical slowdown and a deep structural slowdown, as the Governor set up in the answer. A structural slowdown can occur even if it isn’t deep. Views can vary, but most economists and analysts would probably disagree with the Governor’s conclusion. Also, questions about real interest rates remain poorly answered, creating highly avoidable uncertainty in the minds of investors about the MPC’s response function.

Sitting in the trenches of financial markets, central bank watchers have to keep track of three parameters with respect to the anticipated policy rate changes: What should be done; what is likely to announced; and what is priced in by the price action in financial markets. Globally, policy guidance is meant to lower the uncertainty premium by narrowing the possible outcomes. However, India’s MPC has gone the other way. What will be the size of the next rate cut: 10bp, 15bp, 20bp, 25bp, 35bp or 40bp? Go figure.

The author is Founder & director, Macroshanti Pte Ltd, Singapore. Views are personal