‘It is extremely critical for the MPC to maintain credibility’

was the lone dissenter in the Reserve Bank of India’s (RBI’S) six-member Monetary Policy Committee (MPC) who disagreed with maintaining an accommodative stance in the August review of the monetary policy. Varma is a professor at the Indian Institute of Management, Ahmedabad, as well. In conversation with he says the reverse repo needs to move up and the accommodative stance is not required now. Edited excerpts:

Do you believe the RBI has started the process of normalising the monetary policy as many market participants think? That is, a beginning has been made to end the easy money policy.

To my mind, normalisation starts with moving the reverse repo rate. Right now, the money market is at the reverse repo rate. Until that move, I do not think normalisation has begun.

Do you think the RBI can start normalisation, even if the stance is accommodative?

You can start some normalisation without changing the stance.

What should be the ideal sequence for liquidity normalisation and rate

normalisation? Can rates be normalised only after the gap between the repo and the reverse repo is restored to 25 basis points?

I am coming at it from a slightly different point, that, though the repo rate is 4 per cent, what has happened is that 3.35 per cent (reverse repo rate) has become the effective interest rate in the economy. This 4 per cent has, sort of, become irrelevant. The effective interest rate in the economy is not 4 per cent, but 3.35 per cent. The way I see it is that 3.35 per cent is lower than what is desirable. Interest rate closer to 4 per cent and sustaining that for a reasonable period is what I think is important.

From a long-run point of view, 4 per cent is a much more sustainable interest rate than 3.35 per cent. We should abandon 3.35 per cent and try to prevent rates having to be pushed above 4 per cent as long as possible.

There are some signs of economic recovery. But aggregate demand is yet to pick up, as was stated by some of the members of the MPC. What will a change in stance aim to achieve?

If we go back to the first MPC after the pandemic, which is March 2020, when the repo, reverse repo rates were slashed, they reflected some degree of impact of the pandemic and also the pre-existing recessionary forces in the economy. If we compare the rates of the end of March 2020 with today’s, the rates are significantly lower. If we are coming out of the pandemic, how

is the rate we had set at the worst point still appropriate?

Do you think the MPC risks losing its credibility if inflation stays high?

That is what my whole dissent is about. That, it is extremely critical for the MPC to maintain that credibility. So long as the MPC is credible as an inflation fighter, the severity of action is less. When credibility is weakened, you will need harsher action to achieve the same effect. What may be achieved by a phased normalisation today when the monetary policy is credible, may require a rate hike if the credibility is weakened. So, the way I am looking at it is by removing some of the accommodation which is no longer needed, we reduce the risk of loss of credibility, and inflation becoming more entrenched and ultimately the need for higher rates in the future.

When do you see repo rate moving up?

Given that the economy is still weak and the recovery is still tentative, we would like to postpone a hike in the repo rate as much as possible. The risk is that by keeping rates even more accommodative than the official repo rate, we may be risking that objective. I have a line in the statement, “Easy money today could lead to higher interest rates tomorrow.” By abandoning excessive accommodation, we may be able to sustain a reasonable interest rate policy for long.

I also think that once one takes a longer-term perspective because the downturn in the Indian economy predates the pandemic, and the easing cycle also predates that. The problem is that the easing cycle has lasted for so long and we have still not got the economy on to a robust growth path, and part of the problem has been that the investment is not picking up. The argument that I have been making is that, investment is more a function of long-term interest rates.

If I can borrow money at 3.35 per cent for one month, that’s not going to persuade me to set up a new factory. If I am thinking about setting up a new factory, what is relevant is the rate at which I can borrow 5-year/10-year money. Also, I want a high degree of macroeconomic certainty. It is important to provide that assurance that everything is under control, inflation will be under control, the economy will not be subjected to a disruptive rate hike. It is important to provide the assurance of a stable interest rate, stable inflation over a much longer horizon.

How big a worry is inflation?

The biggest threat to macroeconomic stability is the entrenchment of inflation expectations. That becomes a self-fulfilling prophecy. Inflation goes up because people think it will go up. What prevents that vicious cycle is an independent monetary policy, which focuses on keeping inflation under control.

What is your take on the bond market?

As an MPC member, I would not want to comment. A lot of it has to do with the central bank’s role as a debt manager of the economy. That is not a part of the MPC’S mandate. How the government borrowing programme is managed is a different function. The MPC has no role in that. The monetary policy is completely different from managing government debt. The RBI is playing both roles, but the MPC is not.

You seem to suggest a K-shaped recovery in the MPC minutes. Are you suggesting that whatever it takes to revive growth will only increase inequality as inflation hurts the poor the most?

I don’t want to go that far. What I am saying is in April and May of 2020, everybody was hurt. The monetary policy, by its very operation, is like the tide that lifts all boats. If the tide comes into an ocean, all boats are going to rise; you cannot say I will lift only those boats which are in trouble. When the distress in the economy is no longer generalised, the monetary policy’s ability to redress that is much weaker. The distinction I am making between last year and this year is that, apart from the magnitude of distress following the second wave is lower, the impact is now restricted to some segments. The monetary policy is ill-designed for that.

You have touched upon an important issue regarding the remit of the MPC, by raising the issue of the reverse repo rate. Do you think setting a reverse repo rate should also be part of the MPC mandate?

That is part of the legislative framework and the rules and regulations under which the MPC operates. I think the MPC’S job is to operate within what is there. I think the current regulatory regime clearly says the remit is the policy rate, which is defined to be the repo rate.