The Monetary Policy Committee (MPC) in a five-to-one vote has kept the repo rate unchanged at 4% for the seventh consecutive time, but the panel’s lone dissenting member, Jayanth Varma, believes the key policy rate has become irrelevant.

“The repo rate at 4% is okay, at least, for some period of time but what has happened during our response to the pandemic is that the repo rate sort of became irrelevant,” Varma, IIM-A professor of finance, tells Fortune India in an exclusive interview.

Constituted by the government, the six-member MPC's primary mandate is to determine the interest rate policy required to achieve the inflation target. With the adoption of flexible inflation targeting in 2016, the monetary policy decision making, from a governor-centric process, was vested with the collegial committee.

Varma, along with Ashima Goyal, member of Economic Advisory Council of Prime Minister, and Shashanka Bhide, senior advisor at National Council for Applied Economic Research, were nominated to the panel by the government in October 2020.

Elaborating on the context of his view, Varma points out that the interest rate in the money market is not 4% or anywhere near 4%, which is what one would have expected if the repo rate was at 4%. “The entire money market is at 3.35% and sometimes even lower which is where the reserve repo rate is. The vast amount of liquidity has driven interest rates from the repo rate to the reverse repo rate. Even that is okay, but in the pandemic, we also widened the band from what used to be 25 bps to 65 bps, we pushed the entire market towards the lower end. The core of my argument is that 3.35% is no longer appropriate,” explains Varma.

Though the MPC members took note of the inflationary concerns at a meeting held in the first week of August, they felt the need of the hour was to extend support to economic recovery and remain watchful of inflationary pressures. However, Varma was critical of the panel’s stance on the reverse repo rate. As per the minutes of the meeting, Varma expressed his concerns over the fact that the reverse repo rate did not fall within the remit of the MPC and that the announcement of the rate was the governor’s prerogative and not that of the MPC. “Hence, I have no choice but to express my disagreement with the level of the reverse repo rate,” Varma mentions.

In keeping with the growing view among market participants that the inflation numbers are not transient as the central bank and the MPC would believe, Varma, too, articulated his disagreement. “If the inflation rate is 6% in 2021 and is projected to be 5.5%-6% in 2021-22 and is projected to be more than 5% even in the beginning of 2022-23, it's very hard to call this a transient inflation. If something is going to last for more than two full years, it’s very hard to say that this is just a transient phenomenon,” says Varma.

Fearing that the credibility of the panel is being weakened, Varma says, “If inflation becomes entrenched then the consequences of that are very bad. The fear that I have, which I have articulated in my speech statement, is that the credibility of the monetary policy is weakened.”

According to the RBI, the spike in inflation since June is largely on account of adverse supply-side pressures related to disruptions caused by the pandemic. The RBI governor Shaktikanta Das said at the recent monetary policy meeting that the current price shocks are likely to be one-off or transitory. “Weak demand conditions and low pricing power are limiting the extent of their pass-through to output prices," Das said.

Varma, however, believes that if inflationary expectations become very strong, then those expectations will become self-fulfilling. “It becomes a vicious cycle that everybody expects there to be inflation so everybody acts as if there is going to be inflation. Businesses will not be worried about higher costs as they will think the cost can be passed on, while the consumer feels nothing can be done about it. If inflationary expectation becomes entrenched for a period of time then expectation becomes reality, that’s the self-fulfilling nature of those expectations,” says Varma.

To prevent those expectations from becoming self-fulfilling is where the credibility of monetary policy comes into question and having an open-ended accommodative commitment weakens that credibility of the MPC, adds Varma. “That’s a vicious circle which we wanted to avoid. It’s easier to prevent those expectations from taking root than to eliminate them once it has taken root,” tells Varma.

The professor of finance believes that if the MPC finds itself suddenly behind the inflation curve, then breaking those expectations will require a much harsher monetary policy. “We should act now so that we do not have to act too harshly in future…we should end the excessive accommodation represented by 3.35 and try to hold on to 4% for longer than rather risk that inflation getting out of hand and then having to go beyond 4% very, very, quickly and harshly. That's how I visualise the trade-off,” says Varma.

On how long he expects the repo rate to be kept at 4%, Varma explains that it could be an outcome of what the data sets show. “My belief is that the monetary policy is still credible as we have 4-5 years of track record and, therefore, this credibility can be enhanced. If the MPC is seen as acting quickly in response to the changing environment, then that credibility will be retained. A central bank that has lost its credibility needs to take very harsh steps,” says Varma.

The six-member MPC panel—headed by the RBI governor—seems to be sanguine about an economic recovery and consumer price inflation. Das said at the recent policy press meet that while inflationary pressures are evoking concerns; the current assessment is that these pressures are transitory and largely driven by adverse supply-side factors. But Das is of the view that it’s better to be safe than being sorry. “We need to avoid being taken to the point where we need to take very harsh steps. I would like to see inflation come down without ever having to apply the monetary brakes to such a severe extent. The MPC has a mandate to keep inflation under control, we are conscious of that mandate and if we are going to do that then we need not need any harsh measures,” tells Varma.

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