Friday, 2 December, 2022
HomeIlanomicsRBI’s new MPC should focus on transmission. Without that, more rate cuts...

RBI’s new MPC should focus on transmission. Without that, more rate cuts can be pointless

RBI must work towards better transmission mechanism, for which India needs deep & liquid bond market, competitive banking sector & regulatory framework.

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The newly formed monetary policy committee of the Reserve Bank of India is meeting to decide whether the policy interest rate needs to be changed.

The first Monetary Policy Committee was appointed in 2016 when India set up the inflation targeting framework. External members are appointed for a period of four years and their term cannot be renewed. The first committee’s term got over, and the new external members now appointed have met for the first time.

The new committee is likely to keep interest rates unchanged — the new members have just been appointed, and are unlikely to have the background research required for taking a position at the MPC meeting. When their individual statements are made public after a few days, we can examine whether this is true.

In general, when a committee is new, it is expected to be cautious. A new committee is also less likely to dissent with the RBI’s view. At the moment, the RBI view seems to be in favour of a pause, if we go by the minutes of the last meeting.

Also read: Inflation targeting has worked for India, it is one of Modi govt’s defining achievements

State of India’s inflation

India’s inflation target is 4 per cent, with a 2 per cent band on either side of it. But inflation has remained above the target rate, at the upper end of the band of 6 per cent. The prices of vegetables, eggs, meat and fish have been largely responsible for higher inflation. It is largely supply side factors related to the lockdown that are responsible for higher prices.

The effect of demand, on the contrary, is expected to pull prices down, as GDP in the first quarter contracted by nearly 25 per cent. Yet, the new members of the MPC may not wish to cut rates further, given that inflation is above target and there are no good models for inflationary expectations in an extreme event like Covid.

In the last few meetings of the MPC, the RBI has cut the policy interest rate, which determines the cost of credit, many times. Bank lending rates are yet to catch up with the cuts in the repo rate. The transmission hasn’t fully happened.

Even if the policy rate is cut further, there may be poor transmission, given the uncertainties related to Covid-19, and slow bank credit growth. A lot of firms and borrowers are under stress. Before taking a new loan, they may want to have a more certain environment. At the same time, banks are under stress as many borrowers may default now that the moratorium has been lifted.

One option may be to reprice all loans. Now that interest rates have come down, the cost of borrowing for banks is lower. To some extent, banks have a fixed interest liability on existing deposits. However, as interest rates come down, these liabilities also come down. Banks can afford, to some extent, to reduce rates on existing loans. The terms of the loan may be a fixed rate, rather than a floating rate loan. So as a first step, banks would need to do restructuring of loans and to allow businesses to benefit from the reduction in interest rates.

Also read: Why loan restructuring is a welcome move from RBI, and what govt now needs to do for borrowers

Focus on transmission

Thus, the new MPC may wish to focus on transmission of monetary policy. At present, given the consecutive cuts in the policy rate, as well as the lack of transmission seen in the banking sector, focus needs to be put on restructuring and repricing loans to enable credit to expand.

In the four years of the inflation targeting framework, inflation has been low and stable. The first implication is that the credibility of the framework brought inflationary expectations down. Even though interest rates were cut, we still got low inflation rates. In other words, there should be an emphasis on keeping the credibility of the institutional framework of inflation targeting in place. Even though there will be a review of the target inflation rate next year, as mandated by the government to the RBI, the framework should not be tinkered with.

Instead, the RBI should work on improving the transmission mechanism, much more than it has done in the first four years of the inflation targeting framework. For this, Indian financial markets need a deep, liquid and vibrant bond market, a competitive banking sector and a regulatory framework that encourages small and medium enterprises that have an appetite to approach the formal banking sector for credit.

The objective of public sector banking was to reach out to depositors across the country. To a very large extent, India has achieved this. Schemes such as Jan Dhan have forced public sector banks to give banking access to almost the entire population. However, while there has been access for depositors, the same cannot be said about borrowers.

Unless we address the issue of the monetary policy transmission, another 25 basis point cut is quite pointless.

Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.

Views are personal.

Also read: Higher inflation doesn’t mean RBI’s Monetary Policy Committee should increase interest rates


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  1. I am glad that contrary to the opinions of doomsday prophets who hoped to see India’s economy spiriling down, she gives us room for optimism. Banks should be slightly more liberal with the depositors. People depending on interest income are hurting. Present Monetary Policy is working like the proverbial “Rob Peter and Pay Paul”. This must change.

  2. Ila ji’s columns and Ilanomics videos on youtube are absolutely great. No noise, pure economics and good one at that. Doesn’t shy away from saying what needs to be said, esp about PSUs and PSBs while using as much data as possible.

    Coming to the article, going by the title i thought Ila ji would dive deep into the issue of India’s bond market. But this article has been largely about whether or not another rate cut would help since there’s no much transmission due to various reasons.

    I request Ila ji to write in detail about what ails India’s bond markets for one full column atleast. And what she thinks needs to be done. It’d be of great help.

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