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A focus for the RBI

It needs a well-defined objective and policy instrument.

In his maiden monetary policy announcement, RBI Governor Raghuram Rajan unveiled a mix of easing and tightening measures. He raised the repo rate and lowered the bank rate. In July, the RBI had suddenly raised rates to defend the rupee. Since then, the bank rate, or the MSF rate, has become the operational policy rate, the rate at which commercial banks borrow from the RBI. It is too high for the economy today and needs to be reduced even further.

The decision to cut the MSF rate was obvious. That was the easy part. Rajan also raised the repo rate, which used to be the policy rate before the RBI’s actions to defend the rupee in July. This was supposed to indicate the RBI’s intent to target inflation by lowering inflationary expectations. Bringing such expectations down is a difficult task for any central bank. For the RBI, the problem is even more difficult since it must balance multiple objectives, has numerous instruments and is not independent.

Rajan will have to work hard to build the RBI’s credibility as an inflation targeter. He will need to get rid of its multiple objectives and many instruments. He will have to focus on defining the objective of monetary policy and its instrument clearly, building credibility, being consistent and communicating his policy stance to the public. The success of his term will be measured by how well he is able to anchor inflationary expectations and bring down consumer price inflation. The growth slowdown and high food inflation will make inflation forecasting and targeting difficult. So far, the RBI has not managed to communicate clearly because it has too many instruments and unclear objectives.

In the credit policy announcement, Rajan increased the repo rate under the liquidity adjustment facility (LAF) by 25 basis points, from 7.25 per cent to 7.5 per cent. This was clearly intended only as a signal, since restrictions on borrowing from this window were not reversed. While banks can borrow 2 per cent of their liabilities at the MSF rate, after the RBI’s July actions they can borrow only 0.5 per cent of their liabilities under the LAF. The target corridor for the overnight interest rate has the MSF rate on top, the repo rate in between and the reverse-repo rate at the bottom. The narrower this corridor, the clearer the RBI’s policy stance is. Today, this corridor is too wide and the interbank rate has been moving beyond it.

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