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The hidden aspects of monetary policy

Some aspects of the latest monetary policy, however, require a closer look.

Excessive influence of vegetable price shocks 

With GDP growth on a solid footing, inflation is the primary determinant of the monetary policy in its current setup. The headline consumer price index (CPI) inflation has been hovering near 5%, against RBI’s target of 4%. Perhaps this is why RBI is still maintaining its stance as ‘withdrawal of accommodation’.

However, a reasonable argument can be made that the underlying inflation momentum is considerably different from what is seen in the headline numbers. 

A large part of the recent inflation is contributed by vegetable prices, which constitutes 6% of the total CPI basket. CPI inflation excluding the impact of vegetable prices is nearly 3.5%. Given the disproportionate impact of vegetable price inflation on the headline CPI numbers, it is having an excessive impact on the framing of monetary policy.

Given short production cycles and their perishable nature, vegetables are vulnerable to frequent weather shocks and supply chain disruptions. Historically, vegetable prices in India have shown cyclical characteristics with sharp rise and falls, which are materially different from its true ‘inflation trend’. This tends to add an unwanted volatility in the headline CPI numbers, making the assessment of the underlying inflation trend extremely difficult.

Given the volatile nature of vegetable prices in India, there is a case to exclude the ‘one-off price shock’ of vegetable prices and look at the ‘underlying inflation trend’ in the context of monetary policy.

This is not to suggest that RBI should start cutting rates based on ex-vegetable inflation. The rate decision can have multiple considerations. However, allowing volatile and distortionary vegetable prices to dominate the monetary policy setup can lead to policy errors.

Perplexing policy stance

RBI introduced the term ‘withdrawal of accommodation’ in its off-schedule monetary policy announcement on 4 May, 2022, as it kicked-start the rate hiking cycle with a 40 basis points hike in the policy repo rate. The stance was then reflective of RBI’s policy intent as it suggested that the regulator would be withdrawing the monetary stimulus (low rates and high liquidity) provided during the covid-19 pandemic by hiking interest rates and withdrawing liquidity.

It was followed up by a total of 250 basis points of rate hikes, lifting the repo rate from 4% to 6.5% over the 10 months between May 2022 and February 2023. During this period, RBI also sucked out the excess liquidity infused during the covid-19 pandemic as the core liquidity surplus was reduced from about 6.9 trillion in April 2022 to less than 2 trillion in February 2023.

Since February 2023, RBI has kept the policy repo rate unchanged and core liquidity has largely been around same levels, yet the policy stance is the same. Now, with the repo rate near its 2018 peak and the liquidity condition near neutral, the policy stance of ‘withdrawal of accommodation’ has become irrelevant.

Since the market sees the policy stance and timing of its change as a material event, it requires an explanation from RBI to avoid unwanted confusion.

Tactical liquidity management

Liquidity management, though not directly under purview of the monetary policy committee, has a significant impact on the monetary policy. Typically, a tightening monetary policy regime is facilitated by a tighter liquidity condition, while an easing monetary policy requires an easy liquidity condition.

In the liquidity management framework before the covid-19 pandemic, RBI used to conduct regular auctions of fixed rate repo and 14-day variable rate repos for banks to borrow from it, while managing the surplus liquidity condition tactically through need-based variable rate reverse repo auctions. A pre-scheduled liquidity window used to act as a source of stability in the money markets, keeping the overnight market rates mostly near the policy repo rate.

This framework has been tweaked in recent times. Over the past year, RBI has been relying on variable rate repo and variable rate reverse repo auctions to manage the day-to-day liquidity in the banking system. However, the quantum and timing of these auctions are determined tactically based on regular assessments of banking system liquidity by RBI. This has added friction in the liquidity management between the banking system and RBI. Consequently, overnight market rates and other short-term rates have turned more volatile within the policy corridors, adding a layer of uncertainty in the rates markets.

Having highlighted some of the shortcomings of the current monetary policy regime, we do believe that in the larger scheme of things, the current monetary policy regime has benefited the Indian economy and markets enormously over the last many years.


Pankaj Pathak is senior fund manager-fixed income, at Quantum AMC

Source: RBI

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