Communication is an essential 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 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, composed of three external members, three representatives of the RBI and chaired by the governor. By law, it is the highest monetary policy decision-making body in the country, responsible for deciding changes in monetary policy at regular intervals. These changes are then communicated through official statements, with the discussions underlying these decisions also published, so that the public can understand why the MPC decided as it did.
During the early years of IT from 2016 to 2018, the process worked quite well. On days of political announcements, the governor and his deputies attended a press conference to answer questions from the media. But otherwise, the focus was on the MPC, especially its statement, from which the public used to glean important information about monetary policy strategy, i.e. why the rate repo was or was not modified.
From 2019, however, things started to change. The RBI started issuing a separate governor’s statement on the day of the monetary policy meeting, outlining the outlook for inflation and even explaining the decision taken by the MPC. The rationale for this statement was unclear: at best, it overlapped with the MPC statement; sometimes it looked somewhat different, making it difficult for the audience to understand what the political strategy really was.
Consider the MPC’s statement following the June 8 monetary policy review. The MPC highlighted inflation concerns and voted for an increase in the political repo rate. On the same day, a governor’s statement released by the RBI mentioned that the central bank would also remain focused on the orderly completion of the government’s borrowing programme.
The release of two such different statements can be confusing, especially since lower inflation and lower government bond yields are conflicting policy goals.
This is an example of how, over the past few years, a communication gap seems to have opened up between what the MPC said and what the RBI did, thus potentially eroding the credibility of the IT framework. This communication gap will need to be bridged if the RBI is to succeed in bringing inflation back to its target level of 4%.
Why is communication so critical? There are several reasons. But let’s focus on just one, namely the ability of the central bank to influence inflation expectations. If the public thinks the central bank is committed to keeping inflation under control, it will act accordingly. Companies will moderate their price increases, fearing that large price increases 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 this way, it will be easier for the central bank to ensure that inflation actually stays low.
Of course, spikes in commodity prices will inevitably lead to spikes in inflation from time to time. But if inflation expectations are well anchored, then it becomes relatively easy for the central bank to get inflation back to the target level before too long.
The most important task of the MPC, enshrined in the RBI (Amendment) Act 2016 which introduced IT, is to decide the repo rate, as this has long been the keystone of the monetary policy framework of India. Since the early 2000s, policy has aimed to keep overnight money market rates within a corridor, with the lower bound set by the reverse repo rate and the upper bound by the reverse repo rate. Since the width of this corridor was fixed, once the repo rate had been decided, the reverse repo rate was automatically determined and the overnight market rates adjusted accordingly.
But during the Covid-19 pandemic, the RBI constantly adjusted the reverse repo rate even though the MPC kept the repo rate unchanged, meaning the fixed width of the corridor was lost and the MPC has lost any role in determining interest rates. As a result, the remit of the MPC and, indeed, the credibility of the entire IT edifice has been called into question.
In addition, the RBI has introduced a number of new policy instruments, again outside the mandate of the MPC. During the pandemic, it introduced the GSAP program whereby it pre-committed to purchase a number 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 dormant permanent deposit facility rate, the rationale for which was not explained in the statement of the MPC. Unlike central banks in developed countries like the Bank of England for example, all unconventional monetary policy announcements have been kept outside of the MPC statement, raising questions about the role of the committee in deciding actions monetary policy at a crucial moment like the pandemic.
Finally, the RBI intervened in the foreign exchange market to manage the rupee. Foreign exchange interventions by definition influence the domestic monetary base and inflation. Yet the MPC, in its monetary policy statements, does not discuss exchange rate dynamics or exchange rate interventions. Just as he does not discuss RBI interventions in the bond market to drive down yields.
The net result of all these actions is a potential loss of clarity and credibility. There seems to be a growing gap 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 direction of policy should be measured – or what the framework for monetary policy is.
In its last two statements, the MPC indicated that policy would now focus on containing India’s inflation rate. If the RBI is to succeed in this endeavour, the first step must be to close the communication gap, reintroducing a simple and clear policy framework and restoring the central role of the MPC.
The author is Associate Professor of Economics, IGIDR, Mumbai