Communication is a critical element of monetary policy. In the current inflation targeting (IT) regime, the resolution adopted by the Monetary Policy Committee (MPC) and published on the RBI’s website on the day of the monetary policy meeting is an important channel of communication with the public. Yet there seems to be a gap between what the MPC says and what the RBI does.
Under the IT regime, the most important role in communication belongs to the MPC, consisting of three external members, three RBI representatives, and chaired by the governor. By law, this is the highest monetary policy-making body in the land, tasked with deciding monetary policy changes at regular intervals. These changes are then communicated through formal statements, with the discussions underlying these decisions also being published, so that the public can understand why the MPC decided the way that they did.
During the first few years of IT from 2016 to 2018, the process worked quite well. On the days of policy announcements, the governor and his deputies would participate in a press conference to answer questions from the media. But otherwise the focus was squarely on the MPC, especially its statement, from which the public used to glean important information about the monetary policy strategy — that is, why the repo rate was or was not changed.
From 2019 onwards, however, things began to change. The RBI began to release a separate governor’s statement on the day of the monetary policy meeting, presenting an inflation outlook and even explaining the decision taken by the MPC. The rationale for this statement was unclear: At best, it has overlapped with the MPC statement; At times, it has seemed somewhat different, making it difficult for the public to understand what the policy strategy really was.
Consider the MPC statement following the June 8 Monetary Policy Review. The MPC emphasized inflation concerns, and voted in favor of raising the policy repo rate. On the same day, a governor’s statement issued by the RBI mentioned that the central bank will also remain focused on orderly completion of the government’s borrowing programme.
The issuance of two such different statements can lead to confusion, especially as lowering inflation and lowering government bond yields are contradictory policy objectives.
This is an example of how, over the past few years, a communication gap seems to have opened up between what the MPC has been saying and what the RBI has been doing, thereby potentially eroding credibility of the IT framework. This communication gap will need to be closed in order for the RBI to become successful in bringing inflation back to its 4 per cent target level.
Why is communication so critical? There are many reasons. But let’s focus on just one, namely the ability of the central bank to influence inflation expectations. If the public believes the central bank is committed to keeping inflation under control, then it will act accordingly. Firms will moderate their price increases, fearing that large price rises will make them uncompetitive. Meanwhile, workers will accept moderate wage increases, while investors will accept low interest rates on their bond purchases. With everyone acting in this way, it will be easier for the central bank to ensure that inflation indeed remains low.
Of course, spikes in commodity prices will inevitably cause inflation to surge from time to time. But if inflation expectations are well anchored, then it becomes relatively easy for the central bank to ensure that inflation returns to the target level before too long.
The most important task of the MPC, enshrined in the RBI Act (Amended), 2016 that introduced IT, is to decide the repo rate, since this has long been the lynchpin of India’s monetary policy framework. Ever since the early 2000s, policy had aimed to keep overnight money market rates in a corridor, with the lower bound established by the reverse repo rate and the upper bound by the repo rate. Since the width of this corridor was fixed, once the repo rate was decided, the reverse repo rate was automatically determined, and market overnight rates adjusted accordingly.
But during the Covid-19 pandemic, the RBI constantly adjusted the reverse repo rate even as the MPC kept the repo rate unchanged, meaning that the fixed width of the corridor was lost, and the MPC lost any role in determining interest rates. Accordingly, the remit of the MPC and indeed the credibility of the entire IT edifice was called into question.
In addition, the RBI introduced a number of new policy instruments, again outside the remit of the MPC. During the pandemic, it brought in the GSAP program through which it pre-commited to buying a certain amount of dated government bonds in order to control their yields. It then introduced variable reverse repo auctions, and more recently, replaced the reverse repo rate with the long-dormant deposit facility rate, the rationale for which was not explained in the MPC statement. Unlike developed country central banks like the Bank of England for example, all unconventional monetary policy announcements were kept outside the MPC statement thereby raising questions about the role of the committee in deciding monetary policy actions at a crucial time like the pandemic.
Lastly, the RBI has been intervening in the foreign exchange market to manage the rupee. Forex interventions by definition influence the domestic monetary base and inflation. Yet the MPC in its monetary policy statements does not discuss either the exchange rate dynamics or the forex interventions. Just as it does not discuss the RBI’s interventions in the bond market to lower the yields.
The net result of all these actions is a potential loss of both clarity and credibility. There appears to be a growing rift between what the MPC says and what the RBI does. And with the proliferation of policy instruments, it is no longer clear to the public how the policy stance should be measured — or what the monetary policy framework is.
In its latest two statements, the MPC indicated that policy would now be focusing on bringing India’s inflation rate under control. If the RBI is going to be successful in this endeavor, the first step must be to close the communication gap, by reintroducing a simple and clear policy framework and restoring the central role of the MPC.
The writer is Associate Professor of Economics, IGIDR, Mumbai