Using Monetary Policy’s Degrees of Freedom

There are growing calls for the Monetary Policy Committee to look beyond inflation and respond to currency volatility. But the statutory requirement for Flexible Inflation Targeting states “the primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth.”

The MPC, therefore, cannot vary the repo rate in response to currency volatility. 

But the MPC has to and does look at all the variables that can affect future prices and growth, which is a very large data set, including the exchange rate. Communication is focused on inflation because it provides clarity and focus, which are essential for anchoring inflation expectations, a major transmission channel.

Inflation targeting, however, has to be flexibly interpreted in emerging markets because of the dominance of supply and external shocks, various dualities and structural rigidities. The impossible trinity is used to argue for a repo rise or a float, but it holds only at a point of a fixed exchange rate and perfect capital mobility. Flexibility in the exchange rate and the use of prudential capital flow management give degrees of freedom.

Due to global risk-driven capital-flow surges and sudden stops, and the tendency for exchange rates to overshoot, practical emerging-market central banks all accumulate foreign-exchange reserve buffers, intervene in foreign-exchange markets, and use prudential tools to reduce volatility in order to lower risk premia and spreads. Foreign-exchange markets demand an excess forward premium averaging 3% from emerging markets, which shoots up in times of crisis.

Policy Flexibility
Hardliners think intervention is incompatible with inflation targeting and impossible under free capital flows. A float is the buffer that helps the balance of payments to correct. But our exports are competitive, and the large share of commodity imports with full price pass-through leads to inflation that creates real appreciation. Market panic tends to set in, and further depreciation follows. Large depreciation since last year has not improved the balance of payments, even as other emerging-market currencies strengthened while the dollar weakened.

We have had a large capital-account surplus in 29 of the 35 years after liberalisation, which is responsible for the about $600 billion of foreign-exchange reserves we have accumulated. But markets are worried because we have a slight overall balance-of-payments deficit for the third consecutive year. They see it as a structural issue. But this incident is no different from outflows during earlier periods of global risk aversion. It is only prolonged because oil shocks followed the discriminatory US tariffs targeting India.

In 2013 also, a hands-off approach and communication that markets were on their own had led the rupee to sink. Then, the RBI had to come in with heavy market restrictions, some of which worked, but set market development back. 

In volatile times, it is more effective to buy and sell daily. This can be done without damping market volatility as much as was done in 2023. It would avoid the panic bets on a one-way depreciation that often leads to much more in reserve sales compared to the actual BoP deficit.

Doing too little when markets are stressed can lead to having to do too much eventually. 

The one-year dollar/rupee forward premium, which jumped to 5.19% over 2014-19, fell to 1.95% in 2023 but has risen again to 5.9% now. In 2023, banks complained they could not sell hedges, and today firms are not borrowing abroad as hedging is too costly! 

Intervention has to be strategic, and it is wise to let the rupee depreciate in crisis times so outflows take a loss. But if the crisis is sustained, the RBI has to be in the market using its deep market intelligence to get maximum impact for each dollar sold. 

Communication that the rupee is over-depreciated would also help. Some market participants are worried that the RBI wants the exchange rate to depreciate.

Having fallen to a real value near 90, which it last touched during the 2013 taper tantrum, the rupee is seriously misaligned. In the past, it has always reversed towards a real value of 100 after such crises induced. This time, it will require a nominal appreciation to around 88, since our relative inflation is lower.

Rate Myth
Foreign-exchange buffers remain strong and are normally rebuilt as global risk appetite returns. There is no need to pay more for expensive schemes to acquire another few billion. It is better instead to fast-track intended reforms to deepen debt markets, regulations on inflows and for pension funds can be simplified, tax exemptions for investments through GIFT City can be made more transparent, and so on. Agreements with East Asian and BRICS countries on bilateral local-currency bond markets would bring in more participants with diverse views.

Flexible inflation targeting does allow repo-rate increases if currency depreciation is expected to generate sustained inflation. Will this help stabilise the rupee and attract debt flows? The interest-rate defence normally targets the carry trade through a steep rise in short rates. The 200-basis-point rise during the taper tantrum did not work. The tightening of liquidity that has to accompany it would hurt non-bank finance companies and the informal sector. In India, where there are exogenous liquidity shocks and only banks have access to liquidity windows, it is necessary to keep durable liquidity in surplus.

The 10-year government bond yield at about 7% is already high enough to attract interest. The rupee's depreciation is a major factor raising the yield, one reason it has risen since June last year. A repo rise is likely to be interpreted as implying higher risk. Firms are already stressed with higher borrowing and other costs. Foreign portfolio investors will come in freely when rupee stability and reversal are established.

Finally, the pass-through of cost shocks under flexible inflation targeting can differ from the past. Persistence of future inflation much above the target is not yet established. The equilibrium real policy rate also falls under global shocks. Low current inflation gives the space to wait for more data. This is not the time to raise repo rates.