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How the Monetary Policy Committee’s wings were clipped

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Several decisions that are part and parcel of monetary policy are no longer within the purview of the RBI’s monetary policy committee 

The Report on Currency and Finance published in February 2021 made an extraordinary statement that, “in its endeavour to achieve the policy rate voted upon by the MPC (Monetary Policy Committee), decisions involving a change in the RR (Reverse Repo) and the MSF (Marginal Standing Facility) rate and announcements thereof may be shifted out of the MPC resolution to the Reserve Bank’s Statement on Developmental and Regulatory Policies”.  Accordingly, while the Policy Repo Rate (PRR) alone remains in the preserve of the Monetary Policy Committee,  the MSF rate, Fixed Reverse Repo Rate (FRRR) as also the width of the corridor move to the domain of RBI.  This means that, with no public debate, the powers of the Monetary Policy Committee were drastically clipped.

Indeed, Jayanth Varma’s exasperation in the MPC minutes on August 6, 2021 was evident when he said, “if the reverse repo rate does not fall within the remit of the MPC, then the announcement of this rate should be in the Governor’s statement and not in the MPC’s statement”.

While such a step is flawed and the powers should be restored to the MPC at the earliest, it could be interesting to understand the possible compulsions that drove RBI to such an extreme step and its ramifications.

The one year ahead mean inflation expectations of urban households started breaching 9 per cent from November 2019 onwards.  From May 2020 onwards, they increased to 10 per cent consistently before reaching 11.5 per cent in July 2021.  In sync, retail inflation, which had breached 4 per cent in October 2019, surged ahead to 7.6 per cent by January 2020.  Thereafter, during 2020-21, average retail inflation at 6.2 per cent stood stubbornly higher than the upper tolerance threshold level of 6.0 per cent for eight consecutive months ending November 2020.  Core inflation has also persisted at around 6 per cent during recent times.

Amid this rising inflationary backdrop for almost two years (though it owed much to supply disruptions and other extraneous factors), apparently RBI was unable to convince some external members of MPC to continue with unprecedented accommodative monetary policies, which probably led to constraining the MPC’s jurisdiction.

Though no reason was offered behind such an unprecedented step, one elite argument is sometimes heard that the MPC’s jurisdiction is narrow i.e., achieving 4 per cent inflation in a stable manner while supporting growth.  The mandate for RBI is, however, very wide e.g., achieving financial stability, issuance of currency, maintaining integrity in the banking system, financial market and payment system, etc.  On closer scrutiny, this argument merely tries to create a smokescreen and puff up the role of RBI while undermining that of the MPC.  We often forget the simple truth that achieving low and stable inflation is the best medicine for ensuring financial stability, as also help achieving the RBI’s other mandates.

The RBI initially made the width of the corridor between the repo and reverse repo rates asymmetric--the gap between PRR and FRRR (the lower part of the corridor) was widened from 25 bps to 40 bps on March 27, 2020, leading to increase in total width of the corridor from 50 bps to 65 bps.  On April 17, 2020, FRRR alone was further reduced by 25 bps to 3.75 percent thereby taking the total width wider to 90 bps, without consulting the MPC.

Apart from not changing the PRR at 4.00 per cent since May 22, 2020, RBI started injecting enormous amount of liquidity. It introduced discretionary sector-specific measures from 2020-21 e.g., Targeted Long Term Repo Operations (TLTRO) 1.0 and TLTRO 2.0, Government Securities Acquisition Programme (G-SAP) including OMO purchases, Refinance to NABARD, SIDBI, etc., term liquidity for emergency health services and so on.  These led to a primary liquidity injection of as much as Rs. 10 lakh crore thereby generating, with a money multiplier of 1.5, additional system liquidity of about Rs. 15 lakh crore during this period, on top of substantial amount of foreign inflows into the economy.

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That accommodative monetary policy is required during the unprecedented pandemic years is incontrovertible.  What is, however, puzzling is that despite keeping PRR unchanged, RBI’s extra-ordinary accommodative stance continued even with adjusted non-food credit growth stagnating around a mere 6 percent and then sterilizing surplus liquidity.  In fact, RBI had to progressively increase its Variable Reverse Repo Rate (VRRR) auctions from Rs. 2 lakh crore during April-July 2021 to Rs. 4 lakh crore on September 24, 2021 apart from using fine tuning operations and fixed rate Reverse Repo operations for sterilizations. Nevertheless, outstanding net durable surplus liquidity skyrocketed from Rs. 3.9 lakh crore on May 22, 2020 to Rs. 11.8 lakh crore on October 22, 2021.

The pertinent point is, therefore, whether such over-activism in liquidity injection was warranted.  In fact, RBI’s resolve to anchor retail inflation to 4 per cent is getting contaminated with its over-activism.  However, such over-activism has been a win-win-win situation for the Government (financing of the ballooning of net borrowing in 2020-21, and in 2021-22 by RBI through G-SAP and OMOs), the banking sector (exchanging of its illiquid securities with liquid securities from RBI) as well as RBI (building of additional stock of government securities for sterilising surplus liquidity in the absence of Market Stabilisation Scheme (MSS).

Further, RBI’s diligence in anchoring the operating target (weighted average call rate) to the PRR has got unhinged, as it has been prevailing consistently below the FRRR for long now.  Similarly, its transmission of monetary impulse flows rather from discretionary liquidity injections to lending/deposit rates of banks instead of from PRR.

On instruments of sterilization, VRRR auctions up to 14/28 days, fine tuning operations and FRRR are poor substitutes compared to the longer term securities issued under MSS.  Shelving MSS is leading to RBI becoming the likely depository of illiquid securities.  It is difficult for a government with a large deficit to launch MSS, but given the geo-political situation, India could receive huge inflows going forward.  Hence, RBI’s incremental approach may prove inadequate.

The least the RBI should do now is retreat from exceptional liquidity, anchor inflation expectations, retrieve its operational independence and of course restore the MPC’s powers.

Article Source:- Moneycontrol