Introducing India's monetary policy committee
Asia Insights - Introducing India's monetary policy committee
September 23, 2016 | ||||||
India has completed all steps for establishing an MPC-based flexible inflation-targeting framework. In this note we highlight the tenets of the new framework, the policy views of the MPC members and its implications for monetary policy. As per our assessment, the composition of the MPC is neutral to hawkish with only one of the six members a clear dove. The three external members selected by the government are reputed academics and therefore independent, but only one of them has practical experience in monetary policy making. Given the flexibility within the mandated inflation target of ‘4%+/-2% over the next five years’, the MPC needs to communicate its stance on inflation tolerance within the band and the glide path to 4%. We expect only a 25bp rate cut in the rest of this fiscal year given that inflation moderation is largely base-effect driven. The timing is a close call, and we assign a 40% probability to an October cut and 60% to December (our base case view).
With the appointment of the three external monetary policy committee (MPC) members (see India: Government announces three external MPC members, 22 September 2016), the government has finally completed all the necessary steps for establishment of a committee based flexible inflation targeting framework in India. In this note we highlight the tenets of the new framework, the policy views of the MPC members and its implications for monetary policy.
The MPC members
The monetary policy committee will have six members (Figure 1). This includes three internal RBI members – Urjit Patel, R.Gandhi, Michael Patra – and three external members – Chetan Ghate (Associate Professor, Indian Statistical Institute), Ravindra Dholakia (Professor, IIM Ahmedabad) and Pami Dua (Professor, Delhi School of Economics).
Macro and policy views of the MPC members
Figure 2 gives our assessment of the hawk-dove split of the current MPC members and we present their detailed views below. For details on their backgrounds, please refer to the Appendix.
Urjit Patel (hawk)
As chairman of the expert committee that recommended the shift to flexible inflation targeting, he is generally perceived as hawkish. His report (in January 2014) recommended moving to a CPI inflation target of 4% +/-2% and towards positive real interest rates.
However, in our view, he may not be as rigid as Dr Rajan in achieving the 4% inflation goal as early as March 2018. Following the August 2016 policy meeting review, when asked about his interpretation of the 4% +/-2% CPI inflation target for the next five years, he replied that “it is called flexible inflation targeting for a reason and it is our failure if only for three successive quarters we are piercing the upper bound or the lower bound. It [4%+/-2%] is a range and therefore a tad bit of flexibility is endowed even in the definition of what constitutes a failure that the Monetary Policy Committee or the RBI needs to explain”. In our view, his reply suggests that he would be more flexible about achieving the 4% target.
On other aspects, he believes that the output gap is still negative (June 2016) and, even though capacity utilisation has improved, “it still remains comfortably below the point where pricing pressure moves in”. He has been a strong detractor of fiscal profligacy (subsidies) under the previous UPA government. To bind the government to fiscal rules, he has previously recommended having an inbuilt carrot and stick strategy that incentivises state and central governments to adhere to fiscal targets[1][1]. Under his leadership, we expect a continuation of the new liquidity framework (keeping it around neutral) and the RBI’s FX policy (FX intervention for the purpose of reducing INR volatility, rather than to achieve a certain level of exchange rate). His personal views on the banking sector are less known (for more details, please see India: Macro and market implications of Urjit Patel as RBI governor, 21 August 2016).
Michael Patra (hawk)
He is a proponent of the flexible inflation-targeting framework and is seen as hawkish. He believes that, irrespective of their source, inflationary pressures in India are inertial in nature and therefore “monetary policy needs to be wielded in an agnostic manner that nips in the bud – to use an old cliché – any inflationary impulses that are deemed to be more than transient”[2][2] . In another paper, he wrote that the impact of food shocks on overall inflation are slow in fading and therefore, “the argument that the current phase of inflationary pressures is essentially a supply-side phenomenon and monetary policy has little to do or can do little is overwhelmed by the clear and present danger of inflation expectations coming unhinged and taking on a lasting levitation”[3][3]. He further believes that real interest rates have a significant effect on inflation expectations, even more than fiscal policy or exchange rate. Accordingly, monetary policy must respond “with a readiness to stay ahead of the inflation curve so that real policy tightening is achieved3”.
On FX, like Dr Patel, he believes in keeping it market determined. He argues in his research that managing exchange rates to control inflation is not desirable in view of India’s large trade deficits. On the contrary, “the optimal choice is one slanted towards deriving the balance of payments equilibrating properties of the exchange rate that is flexible in both directions2”.
R. Gandhi (neutral)
As deputy governor of the RBI, he has been given charge of the monetary policy department, which was previously under Dr Patel. As such, he is likely to serve on the MPC until a new Deputy Governor is appointed. His focus is on banking. In a recent conclave[4][4], he emphasised the need for consolidation among public sector banks as larger banks benefit from economies of scale and help in risk diversification, while also meeting the growing credit requirements of the Indian economy. He has been a proponent of regulating P2P (peer-to-peer) lending platforms. He believes that increasing technology penetration in financial services can be disruptive for traditional banking, unless they become more amenable to SME financing. Not much is known of his monetary and real economy views.
Chetan Ghate (neutral-hawk)
As a member of the RBI’s technical advisory committee (TAC) and the Urjit Patel committee, he has some practical experience in monetary policy and is supportive of the new monetary policy framework.
In August 2013, he said that the central bank must be “pre-emptive” in the fight against price pressures which can’t be lowered when the benchmark interest rate is below the level of CPI[5][5]. In a recent paper[6][6], he argued that the RBI “should respond to changes in the terms of trade over time in a systematic way…especially since the importance of food inflation in monetary policy setting over the last several years has become increasingly important.”
On growth, he recently stated that capacity utilisation numbers suggest that the Indian economy was operating below potential. He is also sceptical of the ability of public capex to push growth, stating that “public capex (capital expenditure) is a relatively small chunk of total capex in the economy, and so its effects on stimulating private investment will be limited”. He believes that a key reason for poverty in India is lack of job creation in manufacturing where the government is critical for reducing constraints. He believes that “every percentage point of (GDP) growth below 10% represents wasted opportunities in terms of poverty reduction, jobs and schooling for future generations”[7][7]. Overall, we view his policy views as neutral-to-hawkish.
Ravindra Dholakia (dove)
He stands clearly on the dovish side of the policy spectrum. He believes that a “booster dose of aggregate demand policies may not create the problem [of high inflation over a long period] in a rapidly growing developing economy where the potential output grows at 8-9 per cent annually…However, if the central bankers pursue enthusiastically the tight monetary policy to bring down the inflation rate, it cannot be painless.” He was critical of Dr Raghuram Rajan’s assertion that there was hardly any trade-off between growth and inflation. In a 2015 research paper, he argued that deliberate disinflation comes at the cost of sacrificing output and employment. In India’s case, he estimates the sacrifice ratio at 1.7-3.8[8][8].
In his view, inflation appears to be a supply-side problem in India and hence “the government should promptly address supply constraints, allow full utilization of already created capacity, and push the growth wherever possible to create positive business climate”. Given the short-run costs of disinflation, he believes that the “RBI should hold nominal growth of money supply and allow supply side policies by the government to bring down the inflation”[9][9]. Even back in 2011[10][10], he argued that “the current fiscal and monetary policy stance has been strictly anti-inflationary…our findings show that a strategy of slow recovery and following demand contraction policies to control inflation during the recovery phase could be counterproductive”.
Pami Dua (neutral)
We believe she is neutral in her policy views. She has argued that, while in developed countries monetary policy can be effective in controlling inflation via the output gap channel, in developing countries agriculture supply shocks are an important determinant of inflation and therefore monetary policy “should focus not only on the demand side but also on the supply side factors[11][11]”. However, we don’t see her as a dove because in 2009 she wrote that, given the negligible impact of an expansionary monetary policy on growth, “rising inflation expectations might warrant monetary tightening much earlier than anticipated[12][12]”. She believes that excessive fiscal expansion may crowd out private investments in the medium term.
In a paper[13][13], she argued that India was less hit by the East Asian crisis due to the RBI’s FX intervention, monetary tightening measures, capital flow restrictions and weak trade linkages. For India to remain resilient to global shocks, she argued that “we must reduce exposure of the financial sector to speculative markets including real estate and stocks; maintaining fiscal stringency; maintain current account deficit at a low level; reduce volatility in the foreign exchange markets as well as ensure stability in capital flows”.
Given her academic background, there is limited information on her current economic and policy views. Most of her work has been focused on econometric modelling, forecasting and business cycle analysis. She finds that both domestic and external factors (real money supply, real government expenditure, foreign interest rate, forward premium and the domestic inflation rate) have influenced India’s real interest rates in the post-reform period. Similarly, in another paper she shows that the key determinants of the real exchange rate in India are capital inflows and their volatility (jointly), government expenditure, current account surplus and the money supply[14][14].
The flexible inflation-targeting framework
• Objective of monetary policy: The primary objective will be to “maintain price stability while keeping in mind objective of growth.”
• Inflation target: The government has set 4% +/- 2% as the CPI inflation target for the next five years (5 August 2016 until 31 March 2021). The inflation target will be reset every five years.
• Composition of the MPC: The MPC comprises six voting members, with three from the RBI (the governor, the deputy governor in charge of monetary policy and an RBI official nominated by the Central Board) and three government-appointed external members. The MPC will have to determine the repo rate to contain inflation within the specified target range.
• Tenure: The MPC members will hold office for four years with no re-appointment.
• Meetings: The MPC members will meet at least four times each year. The quorum for an MPC meeting will be four members, at least one of whom must be the RBI governor or the deputy governor in his/her absence.
• MPC Voting: Each MPC member will get one vote. In the event of a tie, the RBI governor will have a second or casting vote.
• Meeting minutes: Minutes of the MPC meetings shall be published on the 14th day after every meeting. These will include the vote and statement of each member and the resolution adopted at the meeting.
• Definition of failure: The RBI would be deemed as having failed to meet the inflation target if average inflation is above the upper tolerance level (6%) or below the lower tolerance level (2%) of the inflation target notified for any three consecutive quarters. In the event of a failure, the RBI would need to issue a report to the central government outlining its reasons for the failure, remedial actions proposed and the estimated time period within which it anticipates achieving the inflation target.
Implications
Our current judgement is that the new MPC is more neutral-to-hawkish in its composition, as against our expectations of a neutral-to-dovish committee. In our view, the three selected external members are reputed academics and therefore credible, independent experts. However, there is limited information about the current monetary policy views of these members. Chetan Ghate, who was a member of the technical advisory committee, has some experience in dealing with monetary policy issues, but the other external members (Ravindra Dholakia and Pami Dua) do not have any recent exposure to monetary policy and therefore may take some time to familiarise themselves with the new task at hand. Technically, the upcoming 4 October monetary policy meeting could now be MPC-based, but this is not yet confirmed and could be a challenge, in our view, given the very few days left before the next meeting.
Despite the framework being institutionalised and inflation target fixed, there is a reasonable degree of flexibility within its tenets. The MPC still needs to clearly communicate its views on the following issues:
1. 4% target: Would the new MPC be comfortable with inflation as long as it is within the 4% (+/-2%) range or will it strive to achieve the mid-point of 4%?
2. The timing of the glide path to 4%: Under Dr Rajan, the RBI had set itself an internal timeline of lowering inflation to 4% by March 2018 itself. The MPC could technically extend the glide path further out, accepting a slower pace of disinflation.
3. Liquidity framework: The RBI introduced a new liquidity framework in April. Will the new MPC continue to provide durable liquidity at the same pace?
In our view, with inflation expected to fall below 5% in coming months and a slow growth recovery, the MPC will likely be opportunistic and cut the repo rate by 25bp. The timing is a very close call and we assign a 40% probability to an October cut and 60% to December (our base case view). By December, the newly formed MPC (particularly external members) would have some time to deliberate and there should also be two sub-5% inflation prints (Sep, Oct CPI) giving the MPC enough ammunition. Beyond a 25bp cut, we expect rates on hold because: (1) the expected moderation in inflation will be base effect driven; (2) underlying CPI inflation is still sticky at ~5%; and (3) there are upside risks to inflation in 2017 from pay commission allowances (100-150bp) and the goods and services tax (20-70bp), which could push CPI inflation above 6%.
Appendix – MPC members and their backgrounds
Urjit Patel: Urjit Patel was appointed as the RBI governor on 20 August 2016, as successor to Dr Rajan. Prior to that, he was the deputy governor of the RBI (since January 2013). He is most known for having spearheaded the committee that recommended the current flexible inflation targeting (FIT) monetary policy framework for India[15][15]. Prior to joining the RBI, Dr Patel has worked with the Boston Consulting Group, Reliance Industries Limited and IDFC. He has also previously held positions in the IMF, served as an adviser to the RBI (on the development of debt markets, foreign exchange markets and banking sector reforms) and worked as a consultant in the Finance Ministry. He holds an M. Phil degree from Oxford University and a PhD from Yale University.
Michael Patra: Dr Patra is an Executive Director at the RBI. He has served in various capacities at the RBI since 1985. He was one of the members of the expert committee that created the new monetary policy framework under the chairmanship of Dr Urjit Patel. He holds a PhD in Economics from Indian Institute of Technology, Mumbai, and is a Fellow at Harvard University where he undertook post-doctoral research.
R Gandhi: R Gandhi is a Deputy Governor at the RBI. He was recently given charge of monetary policy when Urjit Patel became the RBI governor. Prior to this he was in charge of Department of Banking Operations and Development, Department of Expenditure and Budgetary Control, among others. He has been the RBI nominee on the board of four public sector banks for five years. He has also served a three-year secondment to the Securities and Exchange Board of India (SEBI). He has a Master’s degree in Economics from Annamalai University, and has postgraduate level certificates in Management Information System from The American University, Washington DC and in Capital Market from the City University of New York, New York.
Chetan Ghate: He is an associate professor of economics at the Indian Statistical Institute, New Delhi. He is member of the Technical Advisory Committee, which advises the RBI governor on monetary policy under the current framework. He was also one of the members of the committee that created the flexible inflation-targeting framework. He holds a PhD from Claremont Graduate School, California. His areas of interest include Macroeconomic Theory and Policy, Growth and Development, Political Economy and Open Economy Macroeconomics.
Ravindra Dholakia: He is an economics professor at IIM Ahmedabad. He has served on various government committees, including as a member of the Sixth Pay Commission (2006-08), a member of the Expert Committee on Restructuring of the State Public Sector Units (2004-08) and Public Debt Management Committee (2005-06). He has also consulted various corporates (Adani enterprises, Union Bank of India) and served as an independent director on the boards of National Commodity and Derivatives Exchange, Power Finance Corporation, Air India, Gujarat State Petroleum Corporation. He has a PhD in Economics from Baroda University and was a post-doctoral fellow at the University of Toronto.
Pami Dua: She is a professor of economics at the Delhi School of Economics. She holds a PhD from LSE and was previously a Visiting Faculty at Yale University. An expert in econometrics and forecasting, Dr Dua was on the RBI’s committee on data and information management in 2014 and a member of the technical advisory group on leading indicators at the RBI (2006 to 2008). She is the Chairperson of the Agricultural Economics Research Centre, at the University of Delhi.
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