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Monetary policy: Smaller rate revisions may not gain traction

Monetary policy implementation has evolved from whatever rate adjustment was needed whenever the central bank decided, to adopting a framework for setting policy rates and communicating decisions at a pre-announced calendar of policy meetings.

By Rajeev Malik

In the spirit of encouraging out-of-the-box thinking and challenging conventional wisdom, RBI Governor Shaktikanta Das floated an idea, of emerging market economies (EMEs) moving away from adjusting policy rates in baby steps of 25 bps in favour of smaller revisions. He was speaking at Governor Talks , on the sidelines of the Fund-Bank Spring Meetings in Washington DC, so his audience was well attuned to the intricacies of the subject.

The idea is unlikely to gain traction, in my view. This is due to a combination of a long established and clear practice that is exceedingly well understood by both central banks and investors. The proposed idea also doesn t offer any upside compared to the combination of the existing convention of rate changes, complemented by effective communication. For now, it is unclear if India s six-member monetary policy committee (MPC) is open to this unconventional proposal, but there perhaps might be another sympathiser on that committee.

Barring China and Taiwan, central banks (or MPCs, where applicable) of key Asian EMEs adjust policy rates in steps of 25 bps. The Monetary Authority of Singapore is unique in practising a currency-centred monetary policy; hence, it doesn t explicitly target interest rates. Most other EMEs do the same.

Who decided that the policy rate adjustments should be a minimum of 25 bps? Well, the implementation of market-based monetary policy in EMEs evolved much later than in developed economies, and most just adopted, and adapted to , the best practices of the time. It has worked exceedingly well.

Monetary policy implementation has evolved from whatever rate adjustment was needed whenever the central bank decided, to adopting a framework for setting policy rates and communicating decisions at a pre-announced calendar of policy meetings. The main motivation was to have discipline via transparent markers, thereby reducing uncertainty around the monetary policy response function. Thus, the day and the time of the announcement of the rate decision is well-flagged, and the size of the rate change isn t surprising most of the time. Essentially, the combination of a pre-announced schedule of meetings and a clear targeting framework reduced uncertainty around monetary policy to a judgement about the size of the change in the policy rate instead of solving for multiple variables.

Specifically, the Governor stated in his speech, monetary policy can be well served by calibrating the size of the policy rate to the dynamics of the situation and the size of the change itself can convey the stance of policy. For instance, if easing of monetary policy is required but the central bank prefers to be cautious in its accommodation, a 10 basis points reduction in the policy rate would perhaps communicate the intent of authorities more clearly than two separate moves one on the policy rate, wasting 15 basis points of valuable rate action to rounding off, and the other on the stance which, in a sense, binds future policy action to a pre-committed direction .

He offered another scenario, Likewise, 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 bps if it has judged that the standard 25 bps is too little, but its multiple, i.e, 50 bps, is too much. This approach can also be useful when the central bank is on a tightening mode and potentially helps avoid policy turnarounds from forward guidance via stances too far into the future which, in a highly volatile global scenario, may not even be a year .

It is hard to imagine that Das isn t reflecting on the experience of his own MPC in recent months. He has so far presided over two meetings of the MPC, but isn t a novice regarding deliberations in prior meetings. India s MPC has had an eventful few months: It raised the policy repo rate (twice) while on neutral; shifted to a calibrated tightening stance; revised back to a neutral stance and lowered the repo rate; and followed through with another rate cut. To be fair, the dramatic changes should be appreciated in the context of India s uncharacteristically below-trend retail inflation and legitimate risks to its sustainability beyond one year, an infant MPC still working to cement credibility, and global economic crosscurrents that affected other central banks as well. However, hitting turbulence isn t a good enough reason for changing aircraft. Also, MPCs are not made of omniscient people and aren t inoculated against misjudging the economic pulse.

There are five interrelated aspects of the Governor s comment to reflect upon. First, he appears to suggest that the size of a policy rate revision smaller than 25 bps could be clearer in expressing the intent behind the move. This is a non-starter. Changes in policy interest rates are significantly more frequent than the revisions to the stance, and every policy rate change cannot carry a signal about either a change in stance or about the myriad comfort levels of the authorities. Indeed, a rate change on its own doesn t say and doesn t need to say anything about the stance or comfort level.That is where effective communication comes in. The quantum of a rate change is decided by the assessment of the need, the urgency, and the available room for revision. On the other hand, the change in the monetary stance is decided by the MPC s confidence about risks to the outlook and whether these allow for multiple adjustments. Indeed, situations where a bigger change in policy rates is needed without a revision in stance are easily conceivable.

Second, monetary transmission of rate changes smaller then 25 bps will be further subdued and delayed given that RBI routinely struggles with basic liquidity management and in ensuring effective and adequate transmission. Third, policy rate cuts smaller than 25 bps would imply that it would take the MPC longer and more policy meetings to reach the desired level of rates than with the conventional 25 bps moves.

Fourth, instead of deliberating one possible outcome (i.e, a 25 bps change), the Governor s unconventional idea will increase the number of possibilities for a rate change that investors will have to grapple with. This is regressive to say the least. Finally, there is a risk of overburdening investors with intermediate combinations that could complicate the mapping of the policy response function. A 20 bps change will show that the MPC is less comfortable with a 25 bps move than it but more comfortable with a 15 bps revision which, in turn, signals greater comfort with the change over 10 bps or 5 bps moves. Are the MPC members even geared to make an inter-temporal tapestry of policy rate decisions of such granularity? Hiking or cutting interest rates say, 1-3 times, isn’t inconsistent with a neutral stance, especially if it is difficult to offer a clear directional signal on interest rates. If there is confusion regarding the cutting of interest rates while maintaining a neutral stance, the MPC needs to make its communication more effective.

Is there support in the MPC for the governor s out-of-the-box idea? One cannot be certain but a section in the February MPC minutes attributed to Ravindra Dholakia seemed odd at the time of publication but perhaps makes better sense now. Dholakia had stated: Under these circumstances, I think space has opened up for a substantial rate cut of about 50 to 60 bps going forward . The figure 60 is an odd choice when rate adjustments have been in steps of 25 bps. Perhaps there already has been some out-of-the-box discussion. There is no harm in questioning a widely accepted and well-understood practice of adjusting policy rates in minimum steps of 25 bps. However, there is little merit in fixing what isn t broken. The Governor is much better off improving the effectiveness of the MPC s communication.

The writer is founder & director of Macroshanti Pte Ltd, Singapore. Views are personal