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Now, over to Mary Poppins

By Mythili Bhusnurmath

Its a first from a conservative central bank that usually prefers to play it safe (read: go by precedent). But in a break from the past, the Monetary Policy Committee (MPC) is meeting a day ahead of schedule and for three days (June 4-6), instead of the usual two. Indeed, even as you read this, MPC is meeting to wrestle with the issue of the right monetary fix to address the complex macro-economic conundrum: rising inflation coupled with a nascent economic recovery-—in a scenario where policy options are getting increasingly limited.

So, how should we interpret this break from the past? As an admission that MPC is as foxed as the best in its field and needs more time? Or, is the change only due to “certain administrative exigencies”, as the official release puts it blandly? Its hard to say. What is indisputable is that given the mix of macro-economic fundamentals and fast-changing global dynamics, even its harshest critics wont grudge MPC an additional day.

Remember, unlike unforgiving commentators who have the benefit of hindsight, MPC has to frame policy for a future thats not only unknown, but also, in baseball coach Yogi Berras words, aint what it used to be. And yet, it cant afford to call wrong.

The problem, to quote Claudio Borio, chief economist, Bank for International Settlements, is “the behaviour of inflation is becoming increasingly difficult to understand. If one is completely honest, it is hard to avoid the question: how much do we really know about inflation process”. The answer: not very much.

Janet Yellen, former chair of the US Federal Reserve, admitted as much. “Our understanding of the forces driving inflation is imperfect… the conventional framework for understanding inflation dynamics could be mis-specified in some fundamental way.” Thats central bank speak for saying the Fed has no clue.

Three Choices

MPC is unlikely to make such an admission. But in terms of rate action, it has only one of three choices: cut rates, maintain status quo and hike rates. Cutting rates is clearly a nono. Not when inflation is inching up, even if growth is far from the turbocharged days before demonetisation and the goods and services tax (GST) took the sheen away. Not when central banks in emerging market economies (Argentina, Indonesia, Malaysia, Philippines, Turkey and China) have raised rates and overseas investors are exiting in droves. Remember, MPC meets just a week before the Federal Open Markets Committee, the rate-setting body of the US Fed, meets to raise interest rates.

So, the choice really boils down to retaining the repo rate (at which RBI pumps in liquidity into the system) at 6 per cent or hiking it—not to an Argentina-like 40 per cent, but by a more moderate 25 basis points.

There are pros and cons to each. Supporters of status quo may argue that a hike in rates could threaten the nascent economic recovery. But market interest rates have already risen-—the yield on the benchmark 10-year bond is up about 100 basis points—never mind that the last policy action was in October 2017, when MPC cut the repo rate by 25 basis points.

MPC Must Act

So, while a rate hike might affect sentiment, its unlikely to materially affect lending rates even as recovery seems to have taken root. According to official data released on May 31, every successive quarter of 2017-18 saw GDP growth rate up 0.7 percentage points, with growth increasing from 5.6 per cent in Q1 to 7.7 per cent in Q4 (December-March 2018). Given the long leads and lags, monetary policy has to be pre-emptive and forward-looking, more so in an inflation-targeting regime.

When inflation is on the rise and an intelligent reading of the tea leaves suggest further rise, MPC must act. Before, not after, the event.

RBI can do its bit to soften the blow. Monetary policy doesnt operate in a vacuum. Availability of credit is as important as its cost. MPC may have a key role in determining the cost of credit. But when it comes to availability, the ball is in the banks court. Economics 101tells you that one of the main sources of money supply (currency with the public plus demand and time deposits) is bank credit to the commercial sector. Banks alone have the unique ability to create money through credit creation.

However, in a scenario where RBI has placed 11 public sector banks (PSBs) under prompt corrective action (limiting their ability to lend), and has restricted lending and wholesale deposit-taking by a few more, the ability of the banking system to create money is severely impaired. This impacts the cost of credit and, even more, its availability.

So yes, a rate hike by MPC, though warranted, may seem harsh. But RBI can take some of the sting away by being pragmatic on the banking front. As the magical nanny, Mary Poppins, told her charges, “Just a spoonful of sugar helps the medicine go down.”

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