Governor Rajan may have boxed himself in with his latest rate-cut guidance

Central banks’ monetary policy communication typically stays away from giving specific guidance about action and timing, and the likely magnitude of change in the relevant policy rate. They spend significant time and energy in highlighting the risks to the outlook for inflation and growth, and in guiding market expectations about the probability of those risks. Ultimately, markets have to assess for themselves - within the prescribed monetary framework - the changing probability of the likely policy response. Unfortunately, the Reserve Bank of India’s (RBI’s) latest policy statement leaves more to be desired.

Governor Raghuram Rajan officially stayed on hold this week. He deserves full credit for resisting the blatant political and industry pressure to cut interest rates. The policy statement, however, carried uncharacteristically odd aspects. While staying on hold, he indicated conditional easing early next year despite signalling balanced risk to its 6 percent inflation forecast for January 2016. The RBI had already downplayed the scope of inflation being better than its 8 percent inflation forecast for January 2015.

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It gets better. Governor Rajan also added that the move could be in-between policy meetings. Frankly, the only thing missing was the magnitude of the move. Perhaps, for completeness’ sake, the Governor should have also categorically mentioned the possibility of a 50 basis points (bps) move!

Specifically, the policy statement said, “if the current inflation momentum and changes in inflationary expectations continue, and fiscal developments are encouraging, a change in the monetary policy stance is likely early next year, including outside the policy review cycle.”

The above guidance is rather unusual. If that wasn’t the case, all central banks would excel in offering conditional guidance about the timing of their next move and also scope flag inter-meeting moves. They don’t.

The bigger oddity of the two was the signal about the possibility of an inter-meeting move. Now, all central banks which follow a pre-announced schedule of policy meetings know that they have the flexibility of moving in-between meetings. However, it is exercised only in unexpectedly extreme circumstances which warrant an immediate policy response because waiting until the next policy meeting - even if a few days away - is undesirable. For example, during the Global Financial Crisis, the RBI eased policy a few times outside of its meeting schedule.

The RBI’s next two policy statements are on 3 February and in early April (specific date has not been announced). CPI inflation data are published around the middle of the month and the Union Budget for FY16 (2015-16) will be announced on 28 February, as is normally the case.

Frankly, it is difficult to be creative about the nature of the sky falling on the Indian economy in early 2015 that forced the RBI to compromise its hard-earned discipline of sticking to policy action in scheduled meetings. For varying reasons, economists and traders expect the first rate cut in February, March or April. Interestingly, hardly anyone is talking about the possibility of a move in January after the December inflation data are announced. Why wait until 3 February since there won’t be any new inflation data?

Now, if the details of the forthcoming Union Budget are not too important for its policy action, then it can ease before the budget. But does it make sense to ease between meetings in the second half of February after the January inflation data are announced but the budget details are unknown? If the budget also matters, then why can’t a move wait until early April when the annual policy for FY16 will be announced and the biannual inflation report will be published, since easing has already been signalled?

Part of the problem created is that, after correctly indicating that no single inflation reading decides policy, the RBI has itself increased the focus on one or two months of inflation data. The risk of a potential positive surprise in inflation data is independent of whether the desired government discipline to stick to the current year’s fiscal outcome is maintained (nearly 90 percent of the full-year fiscal deficit target has been hit in April-October).

Additionally, does the RBI really think that the FY16 budget will be so great that it might justify a move in March instead of waiting until early April? Or maybe the inflation data and the budget will be so good that the central bank will gift an inter-meeting rate cut of 50 bps (100 bps make 1 percent) even in the absence of a crisis-like situation!

The RBI should seriously consider revising the schedule of its bimonthly meetings. Instead of beginning in February and being at the beginning of the month, they should begin in January and be later in the month. This way it’ll have the inflation data for the prior month, and the post-budget monetary policy meeting will be in March, eliminating the possibility of a surprise action). The recommended change will also allow a meeting in late July by which time it’ll have sufficient information about the monsoon as well.

Frankly, Governor Rajan might as well have cut the repo rate this week. The powerful signal from staying on hold despite immense pressure to ease was compromised by the nature of the guidance. A better balance should - and could - have been maintained to complement unchanged rates. .

A key question which will probably remain unanswered is whether the same guidance would have been given if there was no - or significantly less - pressure to cut rates. Inadvertently perhaps, the convoluted compromise has only hurt the very discipline and uncertainty Governor Rajan has so far successfully worked to improve.

The writer is senior economist at CLSA, Singapore. These views are his own