The MPC needs to be congratulated on the timely increase of 25 basis points in the policy rate, despite the majority view in the market that there would be no hike in rates. It is also noteworthy that it was a unanimous decision. Surprisingly, the tone is not hawkish.

Given the global conditions, Fed rate hikes, capital outflows, elevated oil price rise, closing output gap, rising current account deficit and the likely pressures on the fisc in the run up to 2019, a rate hike seemed a foregone conclusion. These coupled with the recent rise in core inflation and inflationary expectations ensured that the MPC bit the bullet. In fact, the money markets and the bond markets have been pricing such a move since February 2018 as can be seen from the accompanying table. It could even be argued that perhaps a rate hike could have been justified even in April. The largest banks, in fact, started increasing the MCLR even before the policy.

Outlook for inflation, growth

The recent MPC forecasts have been closer to the mark, both in regard to growth and inflation. It is also interesting that CPI inflation for 2018-19 has been revised to 4.8-4.9 per cent from 4.7- 5.1 per cent for the first half of 2018-19. This is a much narrower range of projection compared to the 4 or 5 bps range in earlier policies.

For the second half of 2018-19, the CPI forecast that was reduced from 4.5-4.6 per cent to 4.4 per cent in the April policy has now been increased to 4.7 per cent in H2. The key drivers of inflation are clearly oil prices and the overall demand pressures that have pushed core inflation higher. When asked to what extent the currency played a role, the Governor was quick to respond that the only target or anchor used is CPI inflation (and interest rate as the only instrument) as given in the mandate to the RBI.

The Impossible Trinity

Prior to the RBI and the MPC being given a clear inflation target, the RBI’s objective was to ensure monetary and financial stability while meeting the real sector’s requirements for credit. While doing so, the management of the exchange rate and capital account was a major pre-occupation. The policy of calibrated liberalisation of the capital account continues, since large inflows and outflows can frustrate both exchange rate and monetary policy objectives.

It is in this context that the conflict of the impossible trinity — independent monetary policy, open capital account and a managed exchange rate — comes out in the open. From the reply given by the Governor in the media interaction, it can be deduced that the RBI has no exchange rate objective, nor does it use the exchange rate as an instrument for managing inflation.

The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016, to provide for a statutory and institutionalised framework for a Monetary Policy Committee, to maintain price stability, while keeping in mind the objective of growth. The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.

The growth objective is subsumed in the inflation target given to the MPC and it is natural conclude that the impact of any exchange rate appreciation or depreciation on growth and inflation is outside its purview.

If that is so, then why accumulate reserves when there are huge inflows? Foreign exchange reserves are accumulated for various reasons — transactional and precautionary motives — especially when there is no reliable lender of last resort in the international global architecture.

The forex factor

However, when sufficient reserves have been accumulated (by whatever measure one uses), forex market intervention — both on the buying and selling side — can be justified on grounds of financial stability. The resultant liquidity injection or withdrawal is then managed through open market operations, targeting the overnight call rate consistent with the monetary policy rate and stance.

Is then the RBI totally neutral to the impact of real exchange rate appreciation on growth and current account deficit? Or that it does not confront the impossible trinity? Does the increasing integration with global markets not call for the authorities to derive synergies between the quest for monetary stability and an appropriate exchange rate regime, which would be supportive of growth objectives?

(The writer is a former deputy governor of the Reserve Bank of India. Through The Billion Press)