The minutes of the Reserve Bank of India’s monetary policy committee meeting largely used to be a repetition of the policy statement—analysing and going into the details of the decisions but this changed in October 2020 when the MPC was reconstituted to include fresh faces.
The minutes have since been discussing broader issues. One such discussion is the efficacy of the so-called forward guidance. The MPC guides the markets with its policy stance for a certain period to signal its likely course of action. These are important for markets but not all members are in the favour of these time-based guidelines.
For the second time, Jayanth Varma, an MPC member who is a professor of finance and accounting at the Indian Institute of Management (IIM), Ahmedabad, has highlighted the problem with the failure of the RBI’s forward guidance. Here is what he had to say in the latest MPC policy minutes:
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.
Varma goes 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.
This is not the first time Varma is raising these points. Immediately after his appointment, he had made his dissent known on the choice of words MPC used in its forward guidance.
The guidance in the October policy said this: “MPC also decided to continue with the accommodative stance as long as necessary—at least during the current financial year and into the next financial year—to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy while ensuring that inflation remains within the target going forward."
Varma said date-based forward guidance is not a decision but an expectation. In a world that is full of unpleasant surprises, the MPC must be data-driven.“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,” Varma said. Many experts agree with him.
How will the MPC “decide” to remain accommodative if the inflation continues to soar and growth recovers at a faster pace than expected? What if the high inflation forces the panel to hike rates? Can it remain in an accommodative mode? So, maintaining an accommodative stance is an expectation than a decision.
The fundamental point on both occasions—the inefficacy of the forward guidance—has not been discussed by anyone else in the MPC except Ashima Goyal, who in the latest MPC meeting minutes said she supports a move from time-based to data-based guidance. Both Varma and Goyal have a point. If the aim of the October guidance was to flatten the yield curve, it failed as the data shows.
Secondly, the coronavirus outbreak has made economic data so unpredictable. The RBI’s all-out efforts to keep the long-term yields in check haven’t succeeded. Despite a massive liquidity push, retail inflation is persistently high. In this context, should the MPC persists with its forward guidance or simply, as Varma suggests, have the agility and flexibility to respond rapidly and adequately to whatever surprises new data brings? The issue certainly warrants a wider debate.
(Banking Central is a weekly column that keeps a close watch and connects the dots about the sector's most important events for readers.)