Expect volatility as markets suss out new RBI boss
Given how continuity in policy and his inflation-hawk credentials — Urjit Patel authored the report on inflation-targeting and using CPI as the inflation measure—are what won him the top job at the central bank, it will be ironic if bond markets don’t view the appointment as a positive. News reports suggest traders are concerned that, under Patel’s watch, RBI may not ease liquidity which is critical if interest rates are to fall—even under Raghuram Rajan, it took market-players a long while to convince RBI of the need for increased liquidity if transmission was to take place. Which is why, the RBI Governor-designate’s first task will be—both through more speeches and interactions—to convince market participants that he is open to new ideas. Indeed, at his last outing, Rajan made it clear that he was, for a long time, not in favour of foreign exchange swaps which helped save the rupee in 2013—yet, more than anything else, that is what defined the Rajan governorship; it is precisely this open-mindedness that the normally aloof Patel will have to convince the markets he is capable of. While Rajan showed flexibility when speaking of how he may look through the hike in inflation caused by the housing impact of the Seventh Pay Commission—since it would be a one-time affair—the question is whether Patel will interpret his inflation target strictly at 4% or whether he would be happy to treat even a 6% level as consistent with the monetary policy framework as the government would like. Though the monsoons are good this time around, the persistence of food inflation in a supply-constrained economy like India could mean a tight monetary policy if Patel is to interpret his mandate strictly—technically, it will be a committee that will decide on monetary policy, but it is the Governor that will guide it.
Not too much is known about Patel’s views on how to clean up the banking sector mess—unlike his predecessors, Rajan was very active here—and given that many of Rajan’s measures like strategic debt restructuring have not had the desired results, it is important to know if Patel has other solutions in mind especially since toxic assets at PSU banks have doubled to more than R5.5 lakh crore in the last one year.
Two recent research papers put out by the IMF should give pause to a single-minded belief in the power of interest rates and inflation-targeting. One by Prachi Mishra, Peter Montiel and Rajeswari Sengupta points to how inflation-targeting is not as effective in developing countries like India due to factors like the small share of the formal credit market—Mishra works in RBI’s research division, Montiel was a member of Patel’s inflation-targeting committee and Sengupta is at the IGIDR, RBI’s research institute. Another by Sajjid Chinoy, Pankaj Kumar and Prachi Mishra brings out how difficult it is to figure out what caused disinflation over the last few years. Their model shows the ‘new regime dummy’ for inflation-targeting has the greatest impact, but the authors concede it could be capturing other factors like the impact of the dramatic fall in oil prices. The output gap—a 1ppt increase leads to a 52bps fall in inflation—is seen as a big factor but what is not clear is how much interest rates affect this since deficits, supply bottlenecks, and unused capacity, among others, also play a big role. In a nutshell, flexibility has to be the new RBI chief’s mantra.