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Banking Central | Debate on RBI’s ‘forward guidance’ continues

MPC members like Jayanth Varma, had questioned the efficacy of RBI’s forward guidance in the previous policy review meetings

June 07, 2021 / 12:11 PM IST
Reserve Bank of India (RBI) Governor Shaktikanta Das

Reserve Bank of India (RBI) Governor Shaktikanta Das

One less discussed part in the bi-monthly monetary policy announced last week is Reserve Bank of India (RBI) Governor's brief statement on the forward guidance-- something that has been a point of debate for a while among prominent monetary policy committee (MPC) members.

This is probably the first time the RBI has devoted an entire paragraph to clarify on the issue and to acknowledge the shift to state-based forward guidance from a time-based one.

In his statement, the governor Shaktikanta Das described the 'the role and nature of our forward guidance' as “yet another issue that has generated wide-ranging interest and discussion among economists, market participants and analysts.” Das said in April.

The MPC decided on state-based rather than time-based forward guidance, recognising that it is difficult in the context of the pandemic to perfectly foresee how the economy evolves and when the economic recovery gets firmly entrenched.

“Amidst such all-pervasive uncertainty, the Reserve Bank will continue to use all instruments at its command and work to revive and sustain growth on a durable basis. Needless to add, the consistency and credibility of our communications are reinforced by our visible actions,” Das said.

In fact, as mentioned above, some MPC members like Jayanth Varma have been strongly pointing out the problem of credibility of forward guidance for a while.

In the post the April policy review meeting, Varma, who is a professor of finance and accounting at the Indian Institute of Management (IIM), Ahmedabad, yet again highlighted the problem with the failure of the RBI’s forward guidance. Here is what he said then:

"The principal motivation for the forward guidance was to reduce long-term yields in the backdrop of an excessively steep yield curve. Unfortunately, forward guidance has failed to flatten the yield curve and I see little merit in persisting with it anymore.

As the popular quote (often misattributed to Albert Einstein) says: insanity is doing the same thing over and over again and expecting different results. A flattening of the yield curve remains an important goal but, I think it must be pursued using other instruments which largely lie outside the remit of the MPC."

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Varma went on to say:

"There is another reason why time-based forward guidance is no longer appropriate. Experience of the last several months indicates that in the aftermath of the pandemic, forecasting has become more difficult. It is apparent that some economic and statistical relationships have tended to break down in the current exceptional environment.

Consequently, model risk has now become an important issue as evidenced both in large realised forecast errors and in the dispersion of forecasts from different models. Model risk presents a far less tractable problem than the well-defined statistical prediction error of any single model.

In this situation, I think it is not prudent to repose excessive faith in forecasts. Instead, the MPC must have the agility and flexibility to respond rapidly and adequately to whatever surprises new data may bring in future. Time-based guidance is inconsistent with this imperative."

So, the MPC probably decided to make the shift to state-based guidance from time-based taking into account Varma's comments.

Nevertheless, one can say Varma's argument have been accepted by the MPC, finally, with the Governor clarifying that the central bank has indeed moved from a time-based guidance to a state-based guidance, which means the central bank will take a call considering the prevailing economic situation, rather than going for time-based predictions.

But, still the debate is not over. The RBI itself has agreed on the point that in the context of the coronavirus outbreak, economic data has been made unpredictable. Retail inflation is persistently high above the RBI’s mid-term target while growth remains unpredictable.

One senior economist with a prominent rating agency questioned the relevance of RBI's guidance saying when the MPC is on a stated, continuous ‘accommodative’ stance (which means the policy is tilted towards a rate cut or a status quo, never a rate hike) to support economic growth what is the point of repeating the guidance?

Let the debate continue.

(Banking Central is a weekly column that keeps a close watch and connects the dots about the sector's most important events for readers.)
Dinesh Unnikrishnan
first published: Jun 7, 2021 11:41 am