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According to Nomura, a change in the RBI's monetary policy framework with a focus on CPI inflation as the new nominal anchor would have important macro implications and its success depends on the central bank's commitment and ability to adopt institutional changes after introducing the new regime
The Reserve Bank of India (RBI) has set up a committee under deputy governor Dr Urjit Patel to recommend changes to the monetary policy framework with the objective of making it transparent and predictable. According to Nomura, this may be a move towards price stability or inflation targeting instead of the current multiple-indicator approach.
"A change to the RBI's monetary policy framework with a focus on consumer price index (CPI) inflation as the new nominal anchor would have important macro implications," says Nomura in a research report.
However, for inflation targeting to be successful, certain preconditions have to be in place, the report says. "In particular, this calls for full autonomy to be given to the RBI, strict fiscal discipline by the government and a robust banking system. Evidence shows that most countries built up these conditions gradually after adoption."
India's monetary policy framework has been evolving over the past few decades, consistent with the openness of the economy and with the development of financial markets. In April 1999, the RBI introduced the liquidity adjustment facility (LAF) operating through the repo and the reverse repo rate, resulting in dual policy rates. In 2011, the weighted average overnight call money rate was recognized as the operating target of monetary policy and the repo rate was made the sole policy rate. However, the RBI’s liquidity tightening measures – in response to exchange rate depreciation in mid-2013 – made the marginal standing facility (MSF) rate the effective policy rate, diluting the role of the repo rate since then.
The RBI has historically followed a multiple-indicator approach, targeting various inflation metrics like CPI, WPI, core WPI, core CPI, inflation expectations, growth, and fiscal and current account balances, among other variables, sometimes according to its own convenience. This has made monetary policy unpredictable for market participants at times and has also hurt the RBI's credibility as its goal or “the nominal anchor” is unclear.
According to Nomura, the key focus of the Urjit Patel Committee recommendations will be to make the monetary policy framework and/or operative procedure much more transparent and predictable
Price stability instead of a multiple-indicator approach:
We expect the committee to recommend a move towards price stability, i.e. low and stable inflation as the sole policy objective instead of the current multiple indicator approach. Although the multiple indicator approach has worked well so far, the RBI has only one instrument (interest rates) to achieve multiple goals, which may be distracting it from achieving its central objective of price stability.
The move from a multiple-pillar approach to inflation targeting has to be gradual. The main features of inflation targeting are its medium-term focus, the use of an inflation forecast and the explicit public announcement of an inflation target or sequence of targets.
CPI inflation as the new nominal anchor:
The committee will recommend a new nominal anchor for monetary policy. A nominal anchor is a variable that monetary policy can use to direct the expectations of economic agents regarding price levels in the economy and what policy makers may do to achieve them.
India currently has no nominal anchor and there is substantial confusion as to whether the RBI is targeting the WPI, the CPI, a combination of the two or their core measures. In our view, the RBI will move away from WPI inflation as its primary inflation target because it largely reflects tradable goods price inflation, which is more relevant for producers and does not capture inflation in non-tradables (services), which is more relevant for consumers. We believe the debate is more likely to focus on the benefits of adopting headline CPI versus core CPI inflation as the new nominal anchor.
Headline CPI inflation is driven largely by food price inflation and hence is susceptible to supply shocks. The advantage of targeting core CPI inflation is that it excludes the volatile food and fuel categories and includes a basket of services or non-tradable goods. But ignoring headline CPI inflation has its own pitfalls. Food price inflation plays a crucial role in driving inflation expectations in India, which drives wage-setting behaviour and in turn affects core CPI inflation. Headline CPI inflation is also easier to communicate and to understand even for an average household. Therefore, we think it more likely (65% probability) that the RBI adopts headline CPI inflation as the new nominal anchor, and assign a 35% probability to it adopting core CPI inflation as the new anchor.
Numerical inflation targets:
Having adopted an inflation target, we would expect the committee to recommend a numerical inflation target or a sequence of targets that the RBI should announce on CPI inflation and to which it will be held accountable. We believe that the committee may recommend target ranges to which CPI inflation needs to be reduced over time. This may involve requiring that CPI inflation be brought down to 8-8.5% in the next year (11% currently), to 7-8% over the next two years and so on. A staggered and gradually falling inflation target would make it appear more credible.
Continue with the existing liquidity framework:
We expect the RBI to broadly stick to its current framework of: 1) keeping liquidity in deficit for better policy transmission; 2) the repo rate being the sole policy rate and 3) the weighted average overnight call money rate being the operating target of monetary policy. Hence, one instrument (repo) and one target (CPI) appears to be a more likely outcome. Tight liquidity with a greater reliance on the term repo facility to meet the liquidity mismatches would help develop the term money market and encourage banks to rely more on their own deposits for lending.
Impediments to policy transmission: The committee has also been asked to look into the less-than-desirable transmission channel of policy repo rates to bank lending and deposit rates (Figure 4). Historically, liquidity has been an important driver of transmission as it drives banks? cost of funds. Hence, tight liquidity during a hiking cycle (or easy liquidity during an easing cycle) is necessary to accelerate transmission from policy to bank lending/deposit rates.
However, government finances have wreaked havoc with the RBI’s liquidity calculations in the past through either a sudden burst in spending (higher liquidity) or sudden fiscal austerity (liquidity tightening). One way to resolve this is to auction the government's surplus cash balances, which are currently held as deposits with the RBI (Mohanty, 2011). Additionally, government interference in public sector banks’ interest rate decisions needs to be curtailed. Further, increasing the penetration of the banking system is essential to increasing and speeding up the transmission of monetary policy to the real economy.
Setting up a monetary policy committee:
Currently, the RBI has set up a technical advisory committee, which advises it on the desirable stance of monetary policy. However, the final rate decision rests solely with the RBI governor. We believe that the committee could recommend setting up a monetary policy committee with voting members to decide on policy rates with members possibly drawn from the RBI, Ministry of Finance, academia and the corporate sector.
Greater transparency and communication policies:
As recommended by the Committee on Financial Sector Reforms (2009), the RBI could develop and make public its inflation model to give some guidance to market participants on monetary policy decisions. As price stability becomes the RBI's primary mandate, it could produce its own version of the inflation report, which provides detailed economic analysis and inflation projections, on the basis of which interest rate decisions are made. Detailed minutes of the RBI's monetary policy committee may also be publicly released.
According to Nomura, The move from one regime to another cannot be sudden. First, CPI inflation is driven not just by demand, but also by fiscal policy, indexation and other supply-side factors. Hence, if the RBI moves towards a CPI inflation-targeting regime, government policies need to be prudent, otherwise the RBI may end up setting targets that are too ambitious, thereby hurting its own credibility. A central bank can always lower inflation – it has the tools to affect relative prices – but at the sacrifice of growth.
Second, moving to a CPI regime suggests that interest rates will remain higher for longer. We expect CPI inflation to remain elevated at above 9% y-o-y over the next year as well, which will necessitate further policy action. We are currently pencilling in a cumulative 50bp repo rate hike to 8.25% in 2014 and our bias is to the upside.
Third, although there would be some growth sacrifice in the near term, a successful inflation-targeting framework should have positive medium-term benefits for India, Nomura added.
The report of Urjit Patel Committee is due around the end of December.