The Urijit Patel Committee has submitted a report on Monetary Policy that expects to simply what the RBI intends to achieve in its monetary policy.

Choice of the “Anchor” for Monetary Policy

In terms of anchors, the RBI should look only at inflation, says the report, and not at growth.

The RBI currently looks at Wholesale Price Inflation which is hardly reflective of real pressures people face, since it doesn’t look at services and is revised constantly (mostly upwards). The CPI is a better bet, says the report.

In an age where developed countries are flirting with unemployment rates, growth measures, nominal GDP growth and other such metrics to determine monetary policy (apart from inflation) this comes across as a refreshing change that we will use one anchor – and only one anchor – for monetary policy determination. (Oh, but monetary policy doesn’t work below 0% interest rates, so it’s quite likely that if we get to 0%, we’ll have to use other measures, but let’s leave that out for now)

And Target 4% Inflation in 2 years

Finally, a number we can live with. 4% is what they want to target, within 2 years, with a 2% range around it. The first target is to get it down to 8%, within 12 months, and then to 6% which brings it into the acceptable range, by 2 years. After this, the 4% with a 2% range either ways becomes formal policy.

Additionally, the committee says don’t ditch food and fuel price rises just because you think you can’t change it through monetary policy. If food and fuel rates rise, policy rates have to be increased so that those rises don’t move into the “secondary” items.

We Can’t Ignore Food and Fuel Inflation.

Shocks to food inflation and fuel inflation also have a much larger and more persistent impact on inflation expectations than shocks to non-food non-fuel inflation. As such, any attempt to anchor inflation expectations cannot ignore shocks to food and fuel. Furthermore, it is the headline CPI that households use to deflate nominal returns and
therefore headline CPI informs their portfolio choice of financial assets vis-a-vis other categories (like gold and real estate). Therefore, in spite of the argument made that a substantial part of CPI inflation may not be in the ambit of monetary policy to control, the exclusion of food and energy may not yield ‘true’ measure of infl ation for conducting monetary policy.

I’ve been saying this for a long time. “Core” inflation is useless, because you simply can’t ignore food and fuel. All expectations of inflation come from food and fuel, and it is our expectations of inflation that drive our behaviour.

This is a very important change in stance, and I hope the RBI will adopt it.

Bring Fisc Down To 3% by 2016-17

The next government has been told, unequivocally, to get back to the FRBM targets and bring down the fiscal deficit to 3% of GDP by 2016-17. That’s three years from now.

This will require the government to stop administered prices, be it in fuel or in lower interest rates for certain sections of society or in fertilizer prices or in wages (through MNREGA).

More Transparency and Accountability

The RBI must create a monetary policy committee and the result should be only through majority votes, says the report, with the RBI governor and two key members of RBI will be members. Three year, non-renewable, full-time terms for external members, and full minutes reported after two weeks will ensure transparency.

Interest Rates: Move from Repo to Market Determined Rates

Currently RBI only provides one rate – the repo rate, at which banks borrow overnight from the RBI. There’s an MSF rate (which is Repo+1%) for borrowing greater than the repo limit and a reverse repo rate (Repo-1%) which is what banks park money at the RBI at.

The report suggests we move to target market determined rates instead. In phase 1, the idea is to target the overnight inter-bank call money rates. The second phase will target 14 day repo rates, which is where banks bid on rates to pay for money for 14 day terms.

So if rates go higher the RBI will provide more liquidity, and if they are too low, the 14 day repo amounts will be reduced. This should reflect in the market rates too.

Further, to remove liquidity if there is too much money lying around, the central bank should use a Standing Deposit Facility instead of a reverse repo rate, which is a better thing in the sense that there needs to be no transfer of securities.

Finally, they do mention later that liquidity shouldn’t just be added like crazy. A raise in rates to control inflation should be accompanied with constraining liquidity appropriately. This adds up – if they want to keep rates at 9%, then short term rates should be a minimum of 9% whether it’s call money, repo, term-repo or any other short term or overnight borrowing.

I don’t particularly like this bit, but temporary liquidity provisioning should be fine. My problem is about using OMOs (permanent additions to money supply) to handle temporary problems like a high government cash balances.

Tax All Fixed Income Products Similarly

To ensure proper monetary transmission, it’s important to make some instruments similarly attractive to others if they invest in the same kind of underlying instruments.

Today, if you buy an FD, you pay tax on the interest even if it is reinvested. You also have tax deducted at source for FDs. Investing in a Fixed Maturity Mutual Fund Plan (FMP) gives you lower taxes (long term capital gains at lower rates for more than one year, and no tax deduction at source). The FMP could turn around and invest in a bank Fixed Deposit (or a market traded CD).

The committee says tax these similarly. I would agree for FDs that are greater than one year, that there should be no TDS and long term capital gains should apply.

Others

  • Do not use OMOs to manage government bond issuances or yields. Thank Goodness someone mentioned this. It is akin to the RBI funding the fiscal deficit directly!
  • Don’t give all those interest rate subventions or refinance facilities or such things that distort the credit markets.
  • Those small savings schemes (PPF, Post Office Deposits etc.) should be linked to the Government funding rates like the 10-year bond yield instead of being fixed.
  • Reduce SLR – the requirements for banks to hold government bonds with 23% of their deposits – over time.
  • Banks should find a way to push deposit rates downwards if market rates fall, and the RBI should help them figure this bit out. (Good luck!)
  • RBI should build “adequate” forex reserves. (Blech, why not complete the rupee convertibility instead, and have our trading partners use rupees?) And can RBI continue to trade dollars at its whim and fancy? The report recommends no restrictions. I think this has not been fully thought through, even though it is a huge thing in monetary policy.

My View

The views are progressive, except on the forex front. This does clarify policy very much, and it will require many changes to the government operations (reduction of fiscal deficit etc.), RBI liquidity management and in general, financial markets.

If the 4% (with a 2% range) CPI inflation target is taken seriously, then the RBI will raise rates on the 28th. CPI Inflation is at 10% while the target is 8% in one year, and current short term rates are between 7.75% and 8.50%. Yesterday’s 28 day term repo went at a low 8.15%.

To bring inflation down, rates will have to be continuously raised, no matter what the level, to bring CPI down to the target. We might have to see a 0.50% (50 basis point) increase in rates in January, and then 25 basis points every three months until we reach the 6% number.

That will mean banking stress, as banks struggle to navigate the higher rates. It will mean fiscal stress as the government will pay more to renew its debt. It will mean a massive impact on growth (remember, inflation is the only anchor for policy). It will mean a mini-recession of sorts.

Short term rates will increase, and long term bond prices will suffer. I would stay with short term debt mutual funds. Equity markets will take a hit, and I would avoid the rate sensitives.

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