MPC’s communication style: From the “Draghi moment” to “Bernanke moment”

RBI Governor Shaktikanta Das

The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) met earlier this week and announced a non-standard policy rate hike of 40 basis points as questions grew louder over the seriousness of the central bank’s intent in fighting inflation.

If RBI thought the surprise repo rate hike and the 50 basis-point increase in the Cash Reserve Ratio, outside the regular monetary policy cycle, would silence its critics, it was mistaken.

The central bank action and the statement that followed left investors even more confused. It belied the RBI’s own stated desire to communicate its intentions to the market in advance and followed its inaction at the February and April policy meetings.

Also Read: RBI wants smooth policy measures; prefers smaller rate hikes: Source

In February, it projected inflation to slow in 2022-23. India's retail inflation jumped to a 17-month high of 6.95 percent in March. It was the third consecutive month in which inflation was above the 6 percent upper end of the RBI’s mandate, averaging 6.3 percent in January-March.

At the latest off-cycle policy meeting, the RBI said its policy stance remained accommodative after signalling in April its imminent exit from an easy money stance.

Confusion and uncertainty cause trepidation among investors, who like to be guided in the direction that policy makers want to take them.

“Hiking policy rates and keeping its macroeconomic outlook unchanged from the April 2022 MPC meeting without changing projections is confusing,” Nikhil Gupta and Yaswi Agarwal of Motilal Oswal Financial Services Ltd wrote in a note.

The May 4 announcement was perplexing also against the backdrop of the fact that the same MPC had won plaudits in 2020 for its effective communication and management of the markets’ ability to price in forward expectations.

On March 27, 2020, RBI Governor Shaktikanta Das won praise for his empathetic and assertive style of communication that acted as a soothing balm on financial markets that had been roiled by the spread of the COVID-19 pandemic, collapse of risk pricing and the announcement of a national lockdown.

Effectively, it was just one line in the Governor’s statement that sparked confidence the central bank had things under control during one of the worst crises in human history in over half-a-century.

“The need of the hour is to do whatever is necessary to shield the domestic economy from the pandemic,” Das said as the central bank announced a slew of measures to cushion the blow of the national lockdown, including a 75 basis-point cut in the repo rate and a 100 basis-point reduction in the cash reserve ratio of lenders.

The comment was widely cheered as Das’s “Mario Draghi moment” moment.

In the throes of the sovereign debt crisis in 2012, the then President of European Central Bank, Mario Draghi, said in a speech that the central bank will do “whatever it takes” to protect the unified monetary system of the EU, which helped spark a revival in the down-and-out euro.

Das and the MPC scored full marks when it came to using communication as part of the central bank’s monetary policy arsenal. The 21st century has seen central bankers become adept in guiding market expectations through their words as much as through actions.

“I have learnt many things, and one of them is that communication of policy is as important as the content of policy, and is oftentimes more challenging,” former RBI Governor D Subbarao said in 2011, drawing on his experience of steering the economy out of the global financial crisis of 2008.

Nobody understands more the consequences of a central bankers using the wrong words than former US Federal Reserve Chairman Ben Bernanke.

In May 2013, Bernanke’s comment that the Fed could start tapering its massive bond-buying program “in the next few meetings” and the flip-flops that ensued in the aftermath, triggered the mother of all tantrums by global financial markets.

Bernanke’s gaffe received criticism from both inside the Fed and outside, and he later admitted that the inter-meeting period in 2013 “was a little bumpy with respect to communications”.

The sudden non-standard extent of the rate hike (usually 25 basis points) and RBI’s abandonment of messaging its intentions in advance to ensure “orderly evolution of the yield curve” has now left financial markets confused.

At the April MPC meeting, RBI merely tweaked the wording of its accommodative stance to add that it intended “to remain accommodative while focusing on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth.”

The economic situation over the three weeks did not deteriorate enough to panic the rate-setting panel into an emergency rate hike, said fund managers.

Read: RBI's surprise rate hike raises plenty of questions

In fact, the urgency showed by the MPC has fuelled talk on the grapevine that the central bank knows something the markets don’t.

Remember, in the press conference following the April meeting, Deputy Governor Michael Patra also reintroduced the idea that real interest rates (nominal rates adjusted for inflation) in the economy would need to be positive again because India is a developing economy, a view widely held by the central bank prior to the pandemic.

The talk on positive real interest rates sparked debate on what the effective repo rate should be so that the real rate is positive, and led the market to price in rate hikes of as much as 275 basis points over next two years, an IDFC Mutual Fund note said.

The confusion does not stop there.

Governor Das advised investors to look at the 40 basis point rate hike on May 4 “as a reversal of the rate action of May 22, 2020 in keeping with the announced stance of withdrawal of accommodation set out in April 2022”.

Suyash Choudhary, head of fixed income at IDFC Asset Management, argued that the statement spells even more confusion in terms of pricing in future expectations on interest rates.

If the RBI is currently just rolling back the accommodation provided in the aftermath of the pandemic, does it imply that MPC is ready to undertake a hike of 75 basis points at any moment, which was the extent of the rate cut on March 27, 2020.

“...this still serves as one more trigger for confusing market expectations,” Choudhary wrote in a note.

The bond market was clearly caught unaware of the MPC’s intentions this time; prior to May 4, the intentions had been well telegraphed by the panel to ensure transparency and so as to not surprise the markets.

If the MPC, by suggesting that the rate hike was just a reversal of the pandemic support, wanted to quell concerns on its accommodative stance, it ended up having the opposite impact as the bond market started to price in even bigger rate hikes, as reflected in a 50-60 basis-point jump in overnight swaps on May 4, Choudhary noted.

Confusion bred anxiety, as reflected in the 10-year benchmark government bond yield surging more than 28 basis points s to 7.40 percent, the biggest one-day move in recent years.

At the same time, benchmark equity indices sank more than 2 percent on the day and are now below the lows seen on the day of the announcement.

The cost of the communication googly could be significant.

Choudhary believes the confusion over MPC’s intent is causing the bond market to incorrectly price in more rate hikes than the central bank is willing to undertake, which can become a burden for the economy.

He hopes the issue will “get resolved later in the year as more visible signs of a growth slowdown emerge with consequent less fears of second-round effects of inflation”.