I am obviously getting a little rusty these days. I completely failed to understand the initial (positive) reaction of analysts and markets to the Reserve Bank of India's (RBI's) monetary policy review on October 29. Both the bond and equity markets have subsequently "corrected". Though this might be driven partly by a bunch of so-called global factors, I would argue that the slide in bond and equity prices a few days after the policy review also reflected the fact that the RBI's announcement left the monetary environment a little murkier and more difficult to fathom.
Let me start with the "operating rate" that bankers keep referring to. This is effectively the short-term rate that serves as a benchmark for pricing all sorts of things that banks transact in, ranging from short-term fixed deposits to long-term government bonds. Some commentators found indications in the policy review of a return to a single (much cherished by the previous regime) operating rate - the overnight repo rate. They claimed that the central bank was returning to this after a four-month dalliance with a dual-rate regime that involved the repo and the marginal standing facility (MSF) rates. I could be wrong, but my interpretation was completely different. In fact, instead of a single operating rate, we now have four rates.
Here's why. The RBI has introduced two more liquidity windows - the seven- and 14-day repo windows - and in the policy offered more cash to banks at these windows, instead of easing the cap on the overnight windows. The difference between these and the overnight repo and the MSF is that these are not offered at fixed rates but are determined through auctions. Which of these four rates - the repo, MSF or the two term repo rates - becomes the effective rate at any point in time depends on the amount of liquidity in the system. The other way to look at this is that by varying the amount of liquidity in the system (through, say, open market operations), the RBI can choose to raise or lower the short-term benchmark rate at will without going through the motions of cutting or raising the repo rate.
What are the implications? For banks, the multiplicity of rates and not knowing which rate at any point in time they could use as a benchmark, as well as the fact that a couple of these are market-determined (and not fixed), introduce considerable uncertainty in determining the cost of funds. Thus, it might be logical for them to build an uncertainty premium into the yields of assets that they fund. These could range from short-term loans to government bonds that they invest in. In fact, I see the sharp run-up in bond yields after the policy review partly as a process of factoring in this uncertainty premium.
The other source of uncertainty relates to the very target of monetary policy. The two policy statements that the RBI has issued since Raghuram Rajan took over have put considerable emphasis on the need to harness consumer price inflation. The general drift has been that the RBI will now explicitly target a mix of wholesale price inflation and retail inflation.
Markets like specific targets, even though, as I have argued in my earlier columns, setting and defending these targets could actually undermine the central bank's credibility. Thus, the markets would want answers to two questions. First, they would want to know the levels of the two inflation rates that the RBI is targeting. Second, they would want clarity on the precise mix of the two rates. In the absence of clear communication on both these parameters, the markets will indulge in all sorts of guesswork as to whether prevailing conditions warrant a rate increase or not - and, as the flow of inflation data comes in, the bond markets and interest rates could turn extremely volatile.
There are, in my opinion, two things that the RBI needs to do at this stage. First, it needs to give some indication of both the levels of the two inflation rates that it wants to target and the weights that it wishes to assign to each of the two rates. It should also emphasise - and this is the important bit - that these are essentially medium- or long-term targets and in the near term the central bank is unlikely to follow a mechanical ("keep hiking rates until the target is reached") approach. Thus, it would also factor in the extant growth situation in deciding the policy rate. This perhaps sounds a little vague, but this is what discretionary policymaking is all about. Let's not forget recent history that shows that rule-following central banks, such as the European Central Bank, had fallen seriously behind the curve in cutting rates, with serious adverse consequences for the euro zone's economy. I believe that Mr Rajan is doing his best to send this second message in his interaction with the media and analysts. I just hope that the committee set up to revamp monetary policy does not undo this.
However, whatever be its tack in the near term, there can be little doubt that the RBI is deeply concerned about one structural issue. This is the fact that financial savings are going down and banks are perhaps not doing enough to push them up by aggressively gunning for deposits since they have central bank-provided liquidity to fall back on in order to bridge their gaps. The bottom line is that the RBI is likely to be far more tight-fisted about liquidity going forward (the stream of open market operations that banks had come to depend on might just dry up) and interest rates could have an upward bias. Bad news then!