Not raising the reverse repo rate, or the rate at which the central bank borrows from high-street lenders, could make the benchmark ‘irrelevant’ as rates on the ground exceed those on paper, Prof JR Varma, external member of the central bank’s Monetary Policy Committee (MPC), tells Atmadip Ray and MC Govardhana Rangan. If the central bank is embarking on the path of rate tightening and liquidity normalization, it should ‘say it openly’ instead of holding the reverse repo rate, says Varma. Edited excerpts:
Q-How do you see the MPC's decision in relation to the developments at other central banks like the Fed that have become quite vocal about tightening. The BoE has even raised rates twice…
A-What others are doing, we can’t copy blindly. Only thing we can take from others is that the supply shock lasted longer than it was thought earlier. In the US in particular, their response to the pandemic was much through monetary expansion and, therefore, a pullback is bound to happen. Again, the US economy is firing on all cylinders. But here in India, we are much more sluggish in economic recovery. We are still recovering from the pandemic-led disruptions. So, we cannot simply copy what others are doing.
Q-You have referred to the debate on reverse repo rate as 'harmless fetishism' after calling for narrowing of the corridor. Has reverse repo lost its relevance?
A-To me, if you have already raised rates, if money market rates have already been raised to 4%, then what is the harm in moving the reverse repo rate? Why do you want to keep it at 3.35% and make it irrelevant? For some reason, I think the majority of the MPC wants to stick to 3.35% even though it becomes meaningless. It seems, they don’t want to change anything to what was done in response to the pandemic on paper while there have been changes on the ground.
This, to my mind, does not make sense. If you have tightened, then you should come out openly and say we are tightening. We are pushing up the market rates to 3.75-3.80%. If you do that, then you should say it openly, instead of saying reverse repo remains at 3.35%. This is kind of a fetish. I think this type of policy should have been done more transparently.
Q-There is also a feeling that there is a mix-up or muddling of liquidity and monetary operations with these two rates not providing a proper signal. What is your observation?
A-I would like greater clarity on that. But we have to live with the law. The law clearly said that MPC’s mandate is to fix the repo rate and now some people said that it is understood that if we move repo, then reverse repo would also move. We don’t know what people thought at that point of time. My point is, let us be clear about that. If you say that repo and reverse repo are supposed to move together, then it makes sense to talk about reverse repo in the policy. That’s one way to do that.
The other way to do that is to say that as the law says MPC’s mandate is repo rate and reverse repo is not MPC’s purview, then MPC should not talk about it. These are the two choices and I can live with either. The majority of MPC is much more comfortable with, you know, not making things completely clear. It is kind of contradictory to put it in MPC minutes and then say that it’s not in MPC’s purview. You need to be consistent. I don’t care which way the consistency goes. You cannot say it is black and also say it is white.
Q-You have also touched upon the real interest rate. The real interest rate question has arisen with inflation surging. In the past, prolonged negative real rates led to dislocation with investors chasing real assets and moving away from financial markets. What are the risks of keeping rates low for too long?
A-Yes, there are two risks of keeping real interest rates more negative than they should be. And, for longer than they should be. I am not disputing the need for a negative real interest rate in the year before last. In 2020 and at least in the first half of 2021, we needed that because of the economic impact of the catastrophe.
There are two problems with keeping rates low for too long. First, inflation can keep building up and more than inflation, inflationary expectations can build up. It is important to have people’s confidence that RBI will not allow inflation to go out of its hand. If that happens, then inflation expectation remains low. If people are confident that even if RBI does not raise rates this quarter, it can raise the next quarter if things turn bad, and that MPC would act, then inflation expectation itself can act as an anchor. But if you keep the rate unreasonably low for unreasonably long, this expectation can get trenched.
My worry has always been that people may think that whenever inflation comes down to 5%, MPC becomes very happy. That means that even if they target 4%, the true target is 5%. Then expectation of future inflation would also jump. People will think that RBI would do nothing unless inflation touches 6%. My point is that even if you target 4, you may hit 6 because of uncertainties. But if you target 6, you will hit 8. So, we cannot allow people to come to the conclusion that MPC has stealthily increased the inflation target to 5%.
Q-There's already a feeling that the MPC is taking the upper band of 6% as the target, rather than 4%.
A-This is my worry. MPC should be seen to be defending 4% rigorously and should not be seen as having increased the target to 5% or 6%. This is one danger of keeping rates too low for too long. Keeping rates low was absolutely necessary in 2020 but we cannot keep that level too long.
Second problem is that too low rates can lead to asset price bubbles in various asset classes. This is already seen in the global asset market. That’s why your first point on what global central banks are doing becomes important. Even without RBI doing anything, there has been a lot of liquidity in the Indian stock market simply because of what global central banks have done. So, if the Fed tightens, some of the impact will also be felt in the local market. There has been tightening of financial conditions caused by the Fed and the ECB. We must be alert to the kind of liquidity entering the stock market.
So, there are two worries about low rates. One it raises inflation expectations and two it causes asset price bubbles. Expectations need to be anchored to the monetary policy target. If the target is 4%, it is important that people expect that it remains only 4%. I don’t have a problem with rates being low because the economy is not doing well and you can’t keep real interest rates high. But my worry is that it has been kept too low and for too long. And by talking about achieving durable economic recovery, we are telling the world that rates will remain low as long as you can imagine. That becomes a dangerous message to give.
Q-But what do you think is durable economic recovery?
A-It is time to cut out the accommodative stance. If it is growth that is faltering then we should have one response. If inflation is overshooting then we should have another response. It is important to think about what we can do now, not what we will do two months from now. When we are meeting in April, then why talk now about what we will do in April. Things will change in between.
Q-There is a forward guidance that rates will be low for now. What do you think of that?
A-Yes, this leads to higher inflation expectation and also this makes the market complacent. That whatever happens, RBI will not change its stance. See, low rate was necessary during the pandemic. The pandemic is really over as far as the Indian economy is concerned.
Q-Prof Varma, you spoke of inflation expectation acting as an anchor. But in the changing geo-political scenario, there are already concerns over the spiraling of prices… At the same time, some expect the Fed may now go slow in raising rates. How do you view this scenario?
A-We do not know how much will be the impact on growth and how much will be the impact on prices. The effect of crude prices is already visible, but there could be an impact on wheat prices. And if the war leads to the decoupling of Russia and China from the rest of the world, then there could be an impact on the global economy. Then the question will be is it a bigger growth shock or is it a bigger inflation shock? Good thing is there is still time for our MPC meeting.
Q-Is the inflation forecast made during the last policy announcement too optimistic? Is it relying more on factors turning good rather than the likely negative surprises? Is there going to be a revision in the inflation forecast?
A-When I look at the chart, it shows a non-trivial chance that inflation could end up near the upper band of 6%. That is the risk we are talking about. But, we are only talking about going to a neutral stance and going into wait and see mode. In another quarter or so, we will have greater clarity on how the inflation outcome is panning out. And we can react to that. At present, the uncertainty is very large.
Q-There has been debate about inflation. But there is not much debate on how the supply of money contributed to inflation. Central banks have pumped trillions of dollars. How much of this has caused inflation?
A-First of all, money printing has been limited in the emerging markets. They don’t have the luxury to do that. It’s mainly the advanced economy which expanded money supply a great deal. In India, on the other hand, credit growth has been very sluggish, which is a worry.
The concern of money supply growing too fast is far less in emerging markets. The second thing is that, in the advanced economy, the impact of money printing has been felt in the asset market. So, we can’t extrapolate from the US to us.
Q- St. Louis Fed President James Bullard talked about the credibility of central banks and raising rates to keep the credibility intact. So, what do you think RBI and other central banks should do now?
A-Most importantly, what the MPC and other central banks should do is make the monetary policy data-driven. We should be ready to tighten or loosen depending on data. And there should be a symmetric response to incoming data. And the central banks around the world should take inflation targets seriously and have the weapon to deal with that.
The Open Magazine of India by Artmotion Network (https://magazine.armotion.com/)