A giant leap for India's monetary policy-Indranil Pan, Chief Economist, Kotak Mahindra Bank

The RBI's expert committee has recommended a shift to flexible inflation targeting with the headline CPI inflation as the nominal anchor. However, the committee also recommends that for effective monetary policy transmission, it is necessary to develop a better interest rate framework, with most of the current interest rate distortion being removed. The intention would be to develop the term repo market with RBI having a greater flexibility in managing the 'operative rate' through its liquidity management tools. Further, this would help develop market-based benchmarks that would help improve monetary policy transmission.

Short-term: Negligible chances of rate cut. Long-term: Removal of impediments difficult

If the Governor accepts the recommendations and commits to the timeline for the headline CPI reductions (8% from 10% over next 12 months), it is very unlikely that the RBI will cut repo rate now. Our estimates indicate that with unchanged policy rate, CPI inflation is likely to be 7.5% (March 2015) implying that the RBI could be patient. The patience also emerges from the fact that in the very short term, growth-inflation trade-offs need to be recognized. From a long-term perspective, associated factors of fiscal consolidation, SLR reduction, subventions, etc. will be the primary impediments, which will also be dependent on the larger goals of policymaking in the economy. This could complicate the smooth implementations of the recommendations.

Nominal anchor: Headline CPI inflation to be the target variable

Of the three possible anchors (exchange rate, monetary aggregates and inflation), the RBI views the headline CPI inflation as the best nominal anchor as it unambiguously tasks monetary policy to achieve price stability. This approach clearly highlights the objectives of the RBI and, we believe, would lead to a better understanding for the market in terms of the monetary policy trajectory and objectives. Earlier, growth objectives along with WPI against CPI debates had complicated the market's perception on the reaction function of the RBI.

Flexible inflation targeting: In a phased manner, target to be set at 4% (+/- 2%)

With 57% of the CPI inflation depending on food and fuel, choosing core inflation as a target is not advisable. However, even as the headline inflation is taken as the target, the recommendations advocate for a tolerance band of +/- 2% around the 4% target to adjust for supply shocks in food and fuel. This provides the RBI with a chance to react to the secondary impact of these shocks on inflation and inflation expectations. To move towards the 4% mark, the committee recommends 12-month horizon to lower headline CPI inflation to 8% from 10% currently and in another 12 months to move down to 6%. This number is based on empirical evidence that CPI-Industrial Worker (IW) above 6.2% has been detrimental for growth. After this, inflation targeting will formally be incorporated. However, this is challenging unless administered setting of prices (MSP) and wages (NREGA wages that are now linked to CPI-AL) is totally eliminated.

Operational framework: Develop and deepen the term repo market

The 'end-game' of the operational framework change would be to aim at shifting away from the repo rate as the policy rate and towards a 'target policy rate' for the short-end of the money market. The 14-day term repo rate would be the operating target, which would mean that in next 24 months or more, the term repo market needs to be developed. The committee recommends that in the first phase, the repo rate continues as the policy rate and term repo of 14-day, 28-day, 56-day and 84-day increasingly are used to set up the term money structure. The final aim of the RBI will be to keep the 'target policy rate' for short-end of the money market close to the 14-day term repo rate via liquidity management tools.

Key takeaways from Dr Urjit Patel Committee report

Organizational Structure: Institute a Monetary Policy Committee with voting rights for members

Evolving organizational structure

Institute a five-member Monetary Policy Committee (MPC) with voting rights for each, constituting (1) the RBI Governor as the chairman, (2) the Deputy Governor as the Vice Chairman, (3) the Executive Director in charge of monetary policy as a member and (4) two external members. The external members will be decided by the Chairman and Vice Chairman on the basis of demonstrated expertise and experience in monetary economics, macroeconomics, central banking, financial markets, public finance and related areas. The term of office of the MPC will ordinarily be three years, without prospect of renewal.

However, the new MPC would have a full bearing on the policy decisions. Each member will have one vote with the outcome determined by majority voting. The MPC will meet once in every two months, but it will retain the discretion to meet and recommend policy decisions outside the policy review cycle.

MPC accountability. To strengthen the accountability of the monetary policy targeting, the MPC will have to issue a public statement, stating the reasons for failure to establish and achieve the nominal anchor, remedial actions proposed and the likely period to return inflation to the center of the target zone. Failure here is defined as the inability to achieve the inflation target of 4% (+/- 2%) for three successive quarters. The MPC will also start publishing biannual report on inflation.

Operational framework: Phased transition to 14-day term repo rate as 'operating target rate'

Phase I

The weighted average call rate will remain the operating target, and the overnight LAF repo rate will continue as the single policy rate. The reverse repo rate and the MSF rate will be calibrated off the repo rate with a spread of (+/-) 100 basis points, setting the corridor around the repo rate. The repo rate will be decided by the MPC through voting. Liquidity provision by the RBI would be restricted to specified ratio of bank-wise NDTL consistent with price stability.

As the 14-day term repo rate stabilizes, central bank liquidity should be increasingly provided at the 14-day term repo rate and through the introduction of 28-day, 56-day and 84-day variable rate auctioned term repos by further calibrating the availability of liquidity at the overnight repo rate as necessary. In this phase, the RBI will manage liquidity and meet the demand for liquidity of the banking system using a mix of term repos, overnight repos, outright operations and the MSF consistent with the repo rate set by the MPC.

Phase II

As term repos for managing liquidity in the transition phase gain acceptance, the 'policy rate' voted on by the MPC will be a target rate for the short end of the money market, to be achieved through active liquidity management. Improved transmission of monetary policy thus becomes the prime objective for setting the 14-day term repo rate as the operating target.

Based on its assessment of liquidity, the RBI will announce the quantity of liquidity to be supplied through variable rate auctions for the 14-day term repos alongside relatively fixed amounts of liquidity provided through longer-term repos.

The RBI will aim at keeping 14-day term repo auction cut-off rates at or close to the target policy rate by supplementing its main policy operation (14-day term repos) with (1) two-way outright OMOs through both auctions and trading on the NDS-OM platform, (2) fine-tuning operations involving overnight repos/reverse repos (with a fine spread between the repo and reverse repo rate) and (3) discretionary changes in the CRR that calibrate bank reserves to shifts in the policy stance.

The MSF rate should be set in a manner that makes it a truly penal rate to be accessed only under exceptional circumstances.

New instruments to the monetary policy toolkit

In order to support the new framework, it is recommended that some new instruments be added:

Standing deposit facility (SDF)

To provide a floor for the new operating framework for absorption of surplus liquidity from the system, a (low) remunerated standing deposit facility (analogous to the marginal standing facility for lending purposes) may be introduced, with the discretion to set the interest rate without reference to the policy target rate. The SDF will also be used for sterilization operations, with the advantage that it will not require the provision of collateral for absorption - which had turned out to be a binding constraint on the reverse repo facility in the face of surges in capital flows during 2005-08. However, this will require amendment to the RBI Act.

Longer tenor term repo

Term repos of longer tenor may also be conducted since term repo market segments could help in establishing market-based benchmarks for a variety of money market instruments and shorter term deposits/loans.

Phase out MSS and CMB

Dependence on market stabilization scheme (MSS) and cash management bills (CMBs) may be phased out, consistent with Government debt and cash management being taken over by the Government's Debt Management Office (DMO).

All sector-specific refinance should be phased out

Addressing monetary policy transmission impediments

Given that the transmission mechanism is characterized by long, variable and uncertain time lags, it gets even more difficult to predict the exact impact of the monetary policy action. The RBI studies indicate that in India, monetary policy action impacts output with a lag of about 2-3 quarters and WPI headline inflation with a lag of about 3-4 quarters and the impact persists for 8-12 quarters. In order to reduce the policy lag, which is largely on the back of underdeveloped and incompletely integrated market segments, the report recommends addressing certain impediments to transmission.

Reducing fiscal dominance of the monetary policy

SLR

Consistent with the time path of fiscal consolidation, SLR should be reduced to a level in consonance with the requirements of liquidity coverage ratio (LCR) prescribed under the Basel III framework.

Open Market Operations (OMOs) have to be detached from fiscal operations and instead linked solely to liquidity management. According to the committee, OMOs should not be used for managing yields on government securities.

Small savings scheme

As another source of funding fiscal deficit, small savings have been characterized by administered interest rates and tax concessions. Since the rates on small savings change less frequently, there have been divergences in the bank deposit rates and small savings schemes. The resultant substitution from bank deposits to small savings eroded the effectiveness of the monetary transmission mechanism. The report recommends more frequent intra-year resets of interest rates on small saving instruments, with built-in automaticity linked to benchmark G-Sec yields that need to be brought in.

Subvention

With a sharp rise in the ratio of agricultural credit to agricultural GDP, the need for subventions on interest rate for lending to certain sectors would need to be revisited.

Taxation

The tax advantage of fixed maturity plans (FMPs) and other non-bank financial products should be phased out.

Financial markets pricing benchmarks

The report recommends that it is necessary to develop a culture of establishing external benchmarks for setting interest rates, out of which financial products can be priced. Ideally, these benchmarks should emerge from market practices. The Reserve Bank could explore whether it can play a more active supportive role in its emergence.

Macro-prudential policies

Close coordination is needed between the settings of monetary policy and macro-prudential policies, since variations in macro-prudential instruments such as capital buffers, provisions, loan-to-value ratios and the like alter the cost structures and lendable resources of banks, thereby impacting monetary transmission.

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