The imprint of financial stability in RBI policy
The forthcoming Reserve Bank of India (RBI) policy is likely to address the issue of financial stability. With inflation set to stay higher than the upper band of RBI inflation target and given that inflation expectations in India are adaptive in nature, it will be a surprise if the central bank cuts again even if it’s token.
The issue of financial stability in monetary policy has always been an unsettled issue, ever since the global financial crisis. For example, the Federal Open Market Committee, even 12 years after global financial crisis, has reached no agreement to date to change the policy framework to handle financial instability or the probability of effective lower bound (ELB) episodes.
In this context, I am tempted to quote former Fed Chairman Ben Bernanke (2003) of how constrained discretion achieves the desired objective of monetary policy making rather than adherence to a strict rule- based approach. The RBI over the past several months has exactly been doing that with great success. One such defining example is the current liquidity framework, which has achieved the unthinkable task of fastest rate transmission in the shortest possible time.
The second example is restoring financial stability through unconventional monetary policy surprises with NBFC sector garnering ~1 trillion in FY21. Several small MFS with much lower rating (A3+ with an equivalent long term rating at BBB) are also now participating in CP market. Given all this, the focus of central bank is likely to maintain adequate liquidity, continuing to address financial stability and addressing the vexed issue of moratorium through a balanced communication with the market.
Interestingly, even as the RBI has taken the Covid crisis with a strong response, some of the measures by the RBI has been surprisingly labelled as not in sync with the MPC; for example, the reverse repo rate cut outside policy. Section 45Z (3) of the amended RBI Act of 2016 clearly states that “The Monetary Policy Committee shall determine the policy rate required to achieve the inflation target”. Nowhere in the MPC’S mandate is there any reference to its role in liquidity management, which remains internal to the functioning of the Bank consistent with its policy stance. As Goodhart (2010) observes, the width of the policy corridor acts as an independent instrument for the central bank in a crisis and an asymmetric corridor is a logical outcome under such. The ECB maintains an asymmetric corridor and the RBI has followed suit amidst the pandemic-induced dislocation.
In a similar vein, there has been criticisms regarding the slowing down of regulatory changes being ushered by the RBI. We must remember that similar to fighting inflation, which can be done either through a process of gradualism as against a cold turkey approach, regulatory changes should not be ushered in at a frantic pace disruptive of economic activity. With the pandemic now occurring, it is natural that such measures are partially relaxed to loosen the stranglehold of deflationary momentum on economic activity and rekindle animal spirits. One must be mindful of the banking system of again not being caught in a pincer movement of intense regulatory monitoring and mounting nonperforming assets!