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Prof JR Varma explains his dissent in Oct-20 policy

Summary:
RBI released the minutes of its Oct-20 policy. As this was the first policy under three new external members, the minutes were important. We knew Prof Varma has dissented on the accommodative stance. But what led to the dissent is explained in the minutes: 40. I have agonized a great deal about dissenting (in part) with a resolution on a narrow technicality when I am in agreement with the spirit of the resolution: am I making a mountain out of a molehill and creating unnecessary confusion? After prolonged deliberation, I have come to the conclusion that a dissent may be painful, but it is more consistent with the obligation of MPC members to express their views independently and candidly. Even when a disagreement is more philosophical than operative, it should not always be relegated

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RBI released the minutes of its Oct-20 policy. As this was the first policy under three new external members, the minutes were important. We knew Prof Varma has dissented on the accommodative stance. But what led to the dissent is explained in the minutes:

40. I have agonized a great deal about dissenting (in part) with a resolution on a narrow technicality when I am in agreement with the spirit of the resolution: am I making a mountain out of a molehill and creating unnecessary confusion? After prolonged deliberation, I have come to the conclusion that a dissent may be painful, but it is more consistent with the obligation of MPC members to express their views independently and candidly. Even when a disagreement is more philosophical than operative, it should not always be relegated to the individual statement; I see some merit in occasionally elevating it to a dissent.

41. My preferred formulation of the forward guidance would have been as follows: “The MPC also decided to continue with the accommodative stance as long as it is necessary to revive growth and mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward. The MPC expects to maintain a low policy rate and an accommodative stance during the current financial year and well into the next financial year.”

42. It differs from the actual MPC resolution in two respects. First, in my formulation, the date based forward guidance is not a decision but an expectation. In a world that is full of unpleasant surprises, the MPC must of necessity be data driven. Covid-19 was an example of a totally unanticipated growth shock that came out of nowhere. If a similarly unforeseeable inflation shock were to hit the economy, I find it hard to believe that the MPC will remain accommodative. In practice, I suspect that the word “decided” only means an intention to remain accommodative as long as realized outcomes do not diverge drastically from what is currently expected. I am firmly of the view that the MPC risks a damage to its credibility when it uses words that do not accurately reflect what it means. I therefore disagree with the choice of the word “decided” when it comes to the date based forward guidance in the MPC resolution.

43. Second, my formulation is for a somewhat longer period and explicitly refers to interest rates. In my view, the principal motivation for the forward guidance is the fact that India has one of the steepest yield curves in the world. The Indian yield curve is extremely steep beyond a maturity of about a year: in the short term segment (1-2 years), the intermediate term segment (2- 5 years) and the long term segment (5-10 years). However, in the money market segment (up to a maturity of nearly one year), the yield curve is close to the reverse repo rate of 3.35% (which is the effective policy rate today because of the liquidity support). To have the desired impact, it is desirable that the forward guidance extend beyond the one year horizon at which the steepness of the yield curve sets in. Forward guidance of six months in the MPC resolution is in my view suboptimal. I would also point out that the weakness of investments in the Indian economy predates the Covid-19 pandemic, and this merits a longer term response that goes beyond six months.  

44. One of the hallmarks of a credible inflation targeting regime is a substantial compression of the inflation risk premium. If the market expects inflation to average close to the target rate of inflation, then, by definition, inflation risk is low and consequently the inflation risk premium should also be very small. What remains is essentially the liquidity risk premium which cannot explain the extraordinary steepness of the Indian yield curve.

45. It appears to me that the steep yield curve reflects a lack of credibility of the MPC’s existing accommodative guidance. The introduction of dated guidance in the MPC resolution is an attempt to solve this problem, and my only difficulty with this solution is the word “decided”. Just as the brakes allow the car to travel faster, the MPC’s guidance will be more effective if it works alongside and not in conflict with its inflation fighting resolve. I prefer the word “expected”
because it would preserve the commitment of the MPC to respond aggressively to inflation shocks that lie well above the upper band of the fan chart (Chart 1 of the Monetary Policy Statement).

Interesting right away. Prof Varma is bringing much needed discussion around yield curves etc as part of MPC decisions which traditionally only looks at macro. RBI MPC gets a much needed variety..

Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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