The MPC framework sidesteps the impossible trinity of independent monetary policy, stable currency markets and free capital flows.
India’s Monetary Policy Committee (MPC) is charged with setting the policy repo rate, and so containing CPI inflation between 2.0 percent and 6.0 percent, while keeping in mind growth.
Does the core premise of this framework, that policy interest rates can control inflation in India in the conventional sense, hold water?
Monetary policy is known to influence other parameters, such as the external sector, savings, investments, and employment. Does their omission from the framework make sense?
Interest rates go well beyond the policy repo rate. Does it make sense to limit the MPC to the policy repo rate alone?
We consider these questions in this article. In a sequel, we will explore alternative frameworks that could be considered.
The Inflation Commission
The core monetary premise is that higher interest rates disincentivise borrowing, and hence bring down consumption, aggregate demand and prices. This is intuitive—and tested by research—in borrow-to-spend economies. India, however, is a borrow-to-produce economy.
RBI data shows that India’s household debt was 11 percent of GDP last year, while private sector debt was 51 percent of GDP. Is it possible that interest rates are more a net input cost for India (like oil prices) and less a net determinant of consumption demand? As Dr. Subbarao has pointed out, we do not have adequate research to establish the relationship between interest rates and inflation in India.
On a separate note, given the nature of India’s CPI basket, RBI and other analysts have frequently erred in forecasting even the direction of CPI, let alone magnitudes.
In all, the interest rate—inflation premise that forms the cornerstone of the current framework is at best untested, and at worst a myth.
The Omission of the Impossible Trinity
The MPC framework sidesteps the impossible trinity of independent monetary policy, stable currency markets and free capital flows. The consequences of this omission came to fore during the fiscal year 2017-18 (FY18).
During FY18, across Current Account Deficit (CAD) and Foreign Direct Investment (FDI), India saw a net permanent outflow of $18 billion. Despite that, INR strengthened during much of the period, and RBI had to mop up $44 billion through its currency intervention. The balance $62 billon of inflows were largely transient “carry” seeking net inflows, across foreign portfolio flows into INR debt, net exporter selling, repatriable deposits placed by non-resident Indians, and unhedged foreign currency debt.
In a “carry trade”, opportunistic players move into a currency that offers high-interest rates, amidst perceived exchange rate stability. The MPC framework set the stage for this trade. It kept INR strong in 2017, worsening the terms of trade against our domestic industry, at a time when our CAD looked vulnerable. There was also the vulnerability of a build-up in reversible currency positions. True enough, when crude oil prices firmed up a year later, much of these transient positions rapidly reversed, causing a sharp depreciation of INR.
The upsurge in transient flows during FY18 then made a strong case for lower short-term INR interest rates. However, currency market considerations are out of bounds under the MPC framework. The RBI instead conducted spot and forward purchases of USD to mop up the inflows. Paradoxically, this furthered the carry trade, since forward USDINR rates were kept attractive by such intervention.
As a corollary, there is no exchange policy framework in India. RBI’s oft-repeated statement that it does not target any level of currency, but only intervenes to control some unstated measure of volatility, can and has been used to justify all manner of intervention and non-intervention by the central bank.
The policy repo rate is not the sole determinant of interest rates in the country. In today’s context, the RBI controlled reverse repo rate is a better anchor for short term rates. Monetary transmission into short-term money market rates depends on the state of banking liquidity, which is entirely determined by the RBI. The term structure of interest rates is influenced heavily by RBI’s market interventions and is out of bounds of the MPC.
Interest rates could also impact areas besides inflation and the external sector. In the current context, low real interest rates could be tilting savers into riskier asset classes such as equities. Interest rates may also influence investment decisions, and hence the creation of jobs.
It is ironic that despite the criticality of job creation for India’s economic progress, it finds no mention in policy deliberations.
Putting it Together
The term structure of interest rates likely impacts multiple areas—the external sector, savings, investment, employment, and inflation. The relationship is likely complex.
By limiting the use of the policy rate to only controlling inflation, we are putting deep faith in an untested relationship in the Indian context. By not even weighing the use of monetary policy for addressing other variables, we could be severely limiting our economic outcomes.
The MPC framework does offer simplicity. However, while we can simplify policy considerations by forcing blinkers in our mandates, that cannot alter the complex workings of finance and economics on the ground.
The other possible justification is that by offering the carrot of lower interest rates, the framework can force the government to maintain financial stability. After all, inflation can be controlled by the government, via controlled food prices and fiscal discipline. So perhaps the framework is the rope tugging the nose-ring of the government camel.
As a corollary, perhaps under the veneer of a simplistic framework, the wise men and women at the RBI and MPC quietly consider all the complex issues relating to financial stability and ensure use of all monetary, macroprudential and other instruments to best optimise across inflation, external sector, savings, investment and financial stability considerations.
If either of the last two is true, that would offer clues around why experts are so deeply distrusted these days.
Either way, the framework is either wrong, or too clever by half, or both. In a sequel, we will explore whether better alternatives could be considered.
-Ananth Narayan is Associate Professor-Finance at SPJIMR. The views expressed are personal.
Read his other columns here.