Dangerous to push policy rate above neutral rate when growth outlook fragile: RBI Monetary Policy Committee member

Monetary Policy Committee (MPC) member Jayanth R. Varma had suggested that the RBI should raise the policy repo rate to 6% [rather than the 5.90% that was achieved by the MPC’s decision to raise the rate by 50 basis points] and then take a pause to allow time for the policy rates to get transmitted, the minutes of the September 28-30 meeting of the MPC show.

“A pause is needed after this hike because monetary policy acts with lags,” Mr. Varma is cited as having said at the meeting, the minutes released on Friday show. “It may take 3-4 quarters for the policy rate to be transmitted to the real economy, and the peak effect may take as long as 5-6 quarters,” he added.

Emphasising that it was dangerous to push the policy rate well above the neutral rate in an environment where the growth outlook was very fragile, he said while the level of economic output had recovered to pre-pandemic levels, it remained well below the pre-pandemic trend line.

“If we raise the repo rate to around 6% at this meeting, that would be a cumulative increase of around two percentage points in just four months. Even this understates the extent of monetary tightening, because, a few months ago, money market rates were close to the reverse repo rate (65 basis points below the repo rate),” he posited. “Taking this into account, the full magnitude of monetary tightening would be well over 250 basis points,” Mr. Varma noted.

Stating that much of the impact of this large monetary policy action was yet to be felt in the real economy, he said much of the policy rate action was yet to be transmitted to even the broader spectrum of interest rates. 

“For example, less than a third of the increase in the repo rate during April-August has been transmitted to retail bank deposit rates. Bank deposit interest rates play a critical role in stimulating savings, dampening consumption demand, and thereby mitigating inflationary pressures,” he emphasised.

“We should hopefully see more of this transmission in ensuing quarters. While there has been much higher transmission from policy rates to lending rates, the transmission from lending rates to the real economy would also take time,” Mr. Varma said.

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Highlighting that it too early to know whether the policy action so far was sufficient or not, he said further tighten without a reality check, would put the RBI at the risk of overshooting the repo rate needed to achieve price stability.

“It is true that inflation is currently well above 6%. However, since monetary policy acts with lags, what is relevant is the inflation forecasts 3-4 quarters ahead,” he said.

“Both the RBI’s forecasts and the survey of professional forecasters show inflation falling to around 5% in the first quarter of the next financial year. Relative to this forecast, a policy rate of around 6% would not only be a positive real rate, but also likely above the neutral rate,” he added.

Mr. Varma also contended that that since economic growth rests on the possibility of a revival of private investment in response to rising capacity utilisation, the panel needed to “be careful to ensure that an unreasonably high real interest rate does not thwart this much needed upswing of the investment cycle.”

Reminding the panel that the statutory mandate restricted the MPC to consider only the two factors of inflation and growth while setting interest rates, he said when seen in the context of the RBI having in the past (between 1998-2013) used interest rates to defend the currency to deal with balance of payments issues it had to be remembered that there had been a conscious legislative choice to let monetary policy be dictated by domestic economic considerations, and leave the external sector to be managed using other instruments. 

“This means that the MPC cannot be guided by the effect of global monetary tightening on the interest rate differential,” he stressed.

Mr. Varma had voted against the second part of the MPC’s policy resolution, wherein the panel said it remained ‘focused on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth’, arguing that the MPC ought to now pause rather than focus on further tightening.