Over to the third FM (monsoon)

RBI’s decision to hold on to the rates on Tuesday was based perhaps on a complete consensus for the first time. With too many moving uncertainties, both at the global and domestic levels, any further cut was supposed to be conditional. The good thing is that RBI has continued to stick to an accommodative mode and this will provide enough cheer to the markets against the backdrop of global uncertainties. As we commonly say in India, it is now over to the third finance minister (monsoon) to determine the inflation outlook.

RBI’s assessment of global conditions in April and June seems to differ. Observing how the central bank has changed its view (from its first review) about the global economy in the second review yesterday, we find that there are indeed some changes. In April, the global outlook appeared quiescent with receding downside risk, but by June, we have a very different narrative. The outlook on Japan has changed. There is no mention of the Brexit anxieties of the Euro area. Except for the view on global trade, there is apparently not much connect between the global outlook in the two policy statements. This clearly indicates how uncertain the global economy has become in the interregnum.

Even though RBI has indicated that there are potential upside risks to inflation, we are fairly optimistic of inflation under shooting the 5% target set for January 2017 for the following reasons. First, RBI’s mention of upside risk in its policy statements is more of a mechanism for quashing the inflationary expectations and less an actual representation of the inflation in later months—given trend analysis shows that for the months after which upside risk was mentioned in the policy statements, most of the time inflation actually declined. Second, since 2012, oil prices in the first half have always been greater than or equal to the second half of that year. The reason is that IMF in its World Economic outlook( WE O) report always projects a better picture at the beginning, only to revise it later. Hence, the recent firming of oil prices may possibly be subdued in the second half of the year and will not pose much risk for inflation. Third, the monsoon is delayed in the current fiscal. Data, since 2001, reveals that there is a 67% probability that delay in monsoon leads to normal or above-normal monsoon. Further, the early arrival of monsoonal so doesn’ t guarantee a normal monsoon. Even in 2009, when India faced a severe drought (rainfall deviated -21.8% from LPA), monsoon was nine days early.

Meanwhile, RBI has purchased R700 billion of dated securities through open market operations this fiscal. This has improved the liquidity situation significantly which is evident from the core liquidity deficit (RBI repo borrowings adjusted for the government’s surplus cash balances), which has moved to R47 billion on June 4 from a peak of R913 billion in March 16.

Related to liquidity is also RBI’s concern over faster policy transmission. MCLR is entirely data dependent, and currently, around 70% of MCLR estimation is ascribed to marginal cost of borrowed funds. However, the issue is that deposits rate growth is at historically low levels (around 9-10%) and a further reduction in deposits rate may lead to outflow of deposits from the system. Importantly, when the FCNR repayment becomes imminent, the possible liquidity outflow and therefore the banks’ need for HQLA under LCR may increase manifold, leading to a scramble for deposits to fund HQLA purchases. This could push up deposits rate temporarily. Hence, the transmission of policy rates will entirely depend on how fast banks can adjust their deposits rate which will subsequently lead to change in MCLR.

Meanwhile, in the context of the fierce discussion in public media regarding extending the tenure of top management at RBI, we believe what is absolutely important is a frank and candid discussion on the credibility of the monetary policy and the independence of RBI.

In essence, monetary policy works through financial markets and it is well known that financial markets are character is ed by a symmetric information. In order to bridge the information gap, central banks signal the intent of their policy decisions by committing in advance to an inflation path or an interest rate target. Adhering to the target—either by achieving it or giving credible explanations for any deviation with a commitment to return to the path—helps enhance credibility. Credibility sustained over a period of time, in turn, fosters reputation of the central bank in delivering on its commitments. Once its reputation is entrenched among economic agents, the central bank can necessarily prod market expectations to where it desires them to be, inconsonance with the objectives of its policy. This is exactly what RBI has been doing and will do further once the monetary policy committee is formed.

As far as RBI independence is concerned, as per former RBI Governor, Dr YV Reddy, the most prominent argument for central bank independence is based on the time in consistency problem. Time inconsistency arises when the best plan currently made for some future period is no longer optimal when that period actually starts. In order to solve the time inconsistency problem, two distinct approaches are argued, the ‘conservative central banker approach’ and the‘ optimalcontract approach ’. While the former is postulated based on a conservative central banker whose aversion to inflation is well known, resulting in enhanced reputation and belief by market participants, the ‘optimal contract approach’ postulates the existence of an optimal contract between the central banker and the government. Historically, there are successful examples of both types of models of central bank independence—the US’s is often seen as an example of a conservative central bank while New Zealand follows the optimal contract approach. We believe, India is a perfect mix of both, given the current scenario.

To sum up, RBI is an extremely credible, robust and sufficiently independent organisation, even in the context of global central banks—that should be the only concern for the media.

The monsoon is delayed in the current fiscal. Data, since 2001, reveals that there is a 67% probability that a delay leads to normal or abovenormal monsoon