Chart of the Week: Reserve Bank of India withstands market pressure to ease

Last week’s decision by the Reserve Bank of India (RBI) to leave its policy rate unchanged at 6.25% took investors by surprise. As our chart shows, market participants had expected a 25 basis point reduction following a negative shock from the government’s decision to recall and replace 86% of all outstanding currency. Following several years when monetary policy has increasingly been seen as the only game in town, the RBI’s decision to lean against market expectations came as a breath of fresh air.

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On November 8, India’s Prime Minister, Narendra Modi, announced the Rs500 and Rs1000 rupee notes were being replaced and would cease to be legal tender overnight. However, insufficient notes were printed, and the country suffered a liquidity crunch as businesses and households were not able to exchange old notes for new ones. Daily withdrawal limits compounded the problem. A short-term negative shock to activity was confirmed by November’s services PMI data, which showed a 7.8 point fall to 46.7 – below the threshold that separates contraction from expansion.

However, monetary policy is ill-equipped to offset demonetisation’s negative effect. If spending has simply been deferred, not permanently displaced, any impact on economic growth should simply be transitory. Moreover, market deposit interest rates have already declined, reflecting a large inflow of funds that was previously held in cash. This will eventually feed through to lower borrowing rates, even without any change in RBI policy.

For several years, in the advanced economies at least, central banks have been increasingly relied upon to support economic activity. And expectations for a policy loosening probably reflected perceptions that it would benefit the economy via confidence effects.  It was refreshing to see policymakers withstand such pressure. The most effective policy the RBI can deliver is to ensure that all India’s banks and ATMs have sufficient amounts of the new currency to meet its citizens’ demands. That would provide a greater boost to confidence than any token 25 basis point policy loosening ever could.

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