By: Suyash Choudhary
The Monetary Policy Committee (MPC) has now delivered a second successive rate cut in the current calendar year. But a bystander only observing the bond and money markets may have been excused in believing that the second cut was actually no cut at all, or indeed maybe even a hike! Thus yields have risen across the board since the April rate cut. The quantum of rise has been between 25 – 50 bps in money market and front end bond yields. This reversal is partly owing to the fact that market positions were heavy going into the policy with participants hoping for an explicit or implicit signaling of change in stance alongside the rate cut. However, even adjusting for this forced recalibration of market positions, it is evident that the market is not transmitting rate cuts. It is thus unreasonable to expect the banking system to do so. The endeavor in this note is to evaluate certain aspects of current monetary policy in light of efficacy of transmission to the bond and money markets.
The Importance of Guidance
It can be argued that the MPC is under-utilizing guidance as a policy tool. One of the enablers for transmission is for market agents to believe in directional continuity in policy for some time. However, in the current framework rate cuts are being administered from a neutral stance. While this ‘hedges’ the MPC and allows flexibility to be data dependent and move in either direction, it also tends to impart a ‘one and done’ kind of impression to market. When the environment is extremely uncertain this kind of an approach may make sense. However, Consumer Price Index (CPI) has now averaged below 4% for the past 2 successive financial years. Also if RBI forecasts come true, it is not likely to be much higher in the visible future as well. It is quite curious then why the stance is still assessed to be neutral. Put another way, does this projection not deserve at least a commitment not to hike from MPC? One probable reason for the reticence could be continued lack of confidence with respect to forecasting the target variable. This may in turn have to do with the target framework being flawed itself. This is discussed in greater detail below.
A Target Variable That One Can Work With
It is apparent that a food heavy variable is fundamentally difficult to target by monetary policy. An additional complication for a system like India’s is the presence of a large alternate financing market where transmission of monetary policy may be particularly muted. Thus the appropriateness of the target variable can well be disputed. However, that is a subject often debated and is not the scope of assessment here. Rather a case can be made that under a flexible inflation targeting mandate the MPC is rigidly targeting a point (4%) in a variable that it has inherently little control on. It is probably a happy coincidence that food inflation started to stabilize and then fall around the same time as the RBI de-facto adopted some sort of a CPI targeting framework (although the mandate was formalized later). Put another way, the issues around the ability to target our CPI via monetary policy have probably not been tested so far. It is to be clarified that the difficulty to target here is being considered only from the view point that the loss of output embedded in bringing down CPI via monetary policy may be much higher, since a large part of CPI may have muted direct response to monetary policy changes.
Given this, and within the constraints of flexible inflation targeting, it may be prudent to evolve a framework in which RBI / MPC have more control over the target variable. As an example, some sort of a real rate framework would be helpful. This will essentially have 2 components: 1> the nominal rate to be used (repo, 1 year treasury bill etc). 2> forecasted average CPI (1 year ahead, for instance). A start was made under the Rajan era but it was half hearted at best and was never seriously pursued. Once these 2 components are defined and frozen, an indicative real rate target range can be devised basis risks to the inflation target. This will also take into account the state of economic growth. Such a framework will still be based on CPI targeting but will make the direct target variable (the real positive rate range) more controllable by monetary policy. It will also potentially remove some uncertainty in forecasted reaction function of the MPC, especially insofar as uncertainties relate to responses to potential near term supply side risks.
As an example, the state of monsoon is a perpetual factor in monetary policy considerations. But it may be argued that even if a bad monsoon constitutes a short term supply side shock to food prices, if the underlying context is that of weak demand, it may not percolate into second round effects. Thus while near term CPI may rise the medium term forecast for CPI may not move materially and hence, under a well defined real rate framework, may be immaterial from a monetary policy standpoint. The framework would require the RBI to more carefully refine its medium term CPI forecasts and, importantly, would refocus attention to the leads and lags in monetary policy. Importantly also, although this discussion is not relevant in the current context, should owing to government policies CPI threaten to rise substantially, RBI / MPC can recalibrate the target band for real interest rates higher to reassure market agents about the seriousness to ensure financial stability. By contrast in the current interpretation of the CPI targeting framework, a sustained substantial breach of 4% may pose a narrative challenge for the RBI / MPC. For market participants, it may pose an interpretation challenge on what reaction to now expect from policy.
In summary, monetary policy may never be comfortable targeting a difficult to target policy variable which is substantially subject to short term supply shocks. Hence it may always tend to have hawkish qualifiers which may in turn impede market transmission. An alternate framework around the same target variable, such as the one proposed above, may partly address this constraint.
The Stance on Liquidity
This is probably the most hotly debated topic with respect to our monetary policy. There is a view that the when rates are being cut, liquidity should be kept in marginally positive territory. Whereas, the preference from the central bank continues to be to keep liquidity in deficit. In some sense this also reaffirms the bias towards ‘low involvement ‘ easing, with consequent information for market agents that impedes market transmission. For instance a 3 month bank CD rate is almost 125 bps over the repo rate currently. While lack of transmission at the longer end may be linked to the fiscal, stickier money market rates should be of immediate concern to a central bank so focused on transmission. This was one of the apparent reasons for Rajan to review liquidity stance in early 2016 when RBI moved to targeting neutral liquidity from 1% of NDLT deficit previously.
It is true that there are various aspects that are impeding monetary transmission, many of which are outside of the RBI / MPC influence. These include fiscal as well as elevated administered rates in the system. Transmission in banks lending rates may also depend upon risk perceptions. However, the discussion here has only been from the market’s standpoint and in a backdrop of even front end bond and money market rates not transmitting policy rate cuts. Also it has only focused on issues that are within the remit of RBI / MPC. A sharper focus on guidance, an enhancement to CPI targeting by introducing a standardized real rate target band that itself responds to evolving risks to medium term inflation forecasts, and a review of stance on liquidity that specifically also accounts for money market rates should all facilitate transmission at least from the fixed income market. These can be supplemented by other measures like for instance the dollar rupee swap that the RBI has recently done that, apart from creating rupee liquidity, also brings down forward hedge costs. Another potential idea could be to allow systematically important AAA Government of India owned / serviced entity corporate bonds to become eligible for borrowing from liquidity adjustment facility (LAF) window of the RBI.
In our view, it is reasonable to expect discussion on some of these going forward. The focus seems to be now on transmission and there is possibility that this is studied under a more practical lens by the new governor. One doesn’t rule out internal resistances, especially as the assessment on growth itself seems to be divergent amongst RBI members. Also both the official current GDP as well as the forecasted mild acceleration may not be sitting well with the information being provided by more concurrent real world indicators. Nevertheless, barring a global adverse shock or a post election domestic policy fiscal and / or reflationary shock, we expect some movement to facilitate greater transmission in the months ahead. This may indeed be a bigger trigger for the bond market as well rather than one more low involvement, neutrally delivered rate cut.
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