India’s monetary policy: The dynamics and the new normal in times of coronavirus
A ‘new normal’ in terms of central banks’ targets may have to be designed taking into account the implications of stopgap measures used to address the current health crisis.
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The dynamics of India’s monetary policy and reforms in the financial sector for the years between 1990 and 2013 are well chronicled and debated. Until 2013, Reserve Bank of India’s (RBI) monetary policy approach was more of a multiple indicators approach, wherein inflation was one of the key factors but not the only one.
RBI's monetary policy approach was more of a multiple indicators approach. Inflation was one of the key factors but not the only one. (Photo: PTI)
Inflation targeting (IT), then, was not on the agenda of the economy’s monetary policymakers. Two set of arguments were extended by experts to not adopt IT framework: First, perhaps, it was not needed in that phase of India’s development, and the second strand of literature states, India was not prepared to adopt a targeted policy on two prime accounts: first, inflation targeting requires an efficient monetary transmission mechanism through the operation of efficient financial markets, and absence of interest rate distortions. In India, although the money market, government and corporate debt and forex markets have indeed developed in recent years, they still have a long way to go; second, till very recently, India did not have a pan-India consumer price index (CPI), which was imperative for targeting inflation.
Until 2013, there was a consistent and explicit difference of opinion on the desirability of inflation targeting in India: while the views from government and some academics tended to favour IT, the RBI for all practical purpose was against it. Until 2009, RBI’s multiple indicators approach had been successful: inflation had been contained in mid-single digits for almost 15 years since the mid-1990s. However, the emergence of sustained double-digit inflation (and enhanced inflation expectations) between 2009 and 2013 brought more support for the adoption of inflation targeting. Raghuram Rajan, while taking over as the RBI Governor on September 4, 2013, mentioned that he had deliberations with the then Deputy Governor Urjit Patel, to pen suggestions in three months’ time, along with a panel constituted outside the RBI staff, on what needs to be done to revise and strengthen the economy’s monetary policy framework. After considerable discussions, a Monetary Policy Framework Agreement (MPFA) was finally signed between the Government of India and the RBI on February 20, 2015, specifying the following:
1) Government has set a target for RBI to bring down inflation below 6 per cent by January 2016, 4 per cent for financial year and all subsequent years with band of +/- 2 per cent;
2) If RBI fails to meet the target, it will report to the government with the reasons for the failure to achieve the target and propose remedial actions to be taken;
3) The RBI will further estimate the time period within which the failed target would be achieved.
A numerical inflation target reflects explicitly or implicitly, the meaning of price stability in a country-specific context. Tracing the literature with respect to inflation rate which corresponds to price stability, it was seen that for advanced economies an inflation rate of 1-3% corresponds to price stability, while in-transition economies inflation in the rate of 4-5% would correspond to price stability. The range gives the RBI the advantage that it allows monetary policy to do best what it can do, i.e., it remains sensitive to short run tradeoffs between inflation and growth but pursues the inflation target on average over the course of a business cycle. A band also provides lead information on tolerance levels of monetary policy to accommodate unanticipated shocks which enhances transparency and predictability. Assessing the positive outcomes of flexible inflation targeting, it was formally adopted in India. This inflation target is applicable for the period from August 5, 2016 to March 31, 2021, wherein the MPC determines the policy interest rate required to achieve the inflation target.
India’s recent challenges with IT framework
If the inflation condition in the country is assessed from 2015 to the last quarter of 2017, one may decipher that the inflation targeting has worked in India’s favour with inflation slipping even below the target in January 2016 (5.7 % against the target of 6%), 3.2% in January 2017 and 5.1% in January 2018. However, since 2018, low inflation has been accompanied by low growth and since the last quarter of 2019, high rates of inflation have been accompanied by low growth. This then raises the questions on the reasons of failure of the MPC in controlling inflation as per the prescriptions of the Act. Policymakers and academicians are actively discussing, if the MPC has been too conservative in its policy approach or if targeting inflation was like an obsession that has gone immensely wrong for the economy’s overall growth. Growth lobbyists are blaming the high interest regime, which was put in place to safeguard the economy from high inflation, might have actually backfired. Today, the economy is facing a scenario where there are recurring bouts of currency slide and an economy with neither a low inflation rate nor a sustainable growth rate.
While being so overwhelmed by the international experiences of IT, two major disadvantages, especially in the Indian context, were not taken too seriously. These can plausibly explain the worrisome current growth-inflation tradeoff that the economy is exposed to. First, some part of inflation such as from food and fuel is not easily controlled by monetary policy. The true inflation that consumers face, is in the retail market. Although price indices that relate to consumer expenditures are at best imperfect, they are still close indicators of the cost of living. In India, food has 48 per cent weight in the CPI-combined. If food, fuel and light are excluded, in order to arrive at a core inflation measure, 57.1 per cent of the consumption basket will be discarded. Under these circumstances, the CPI-combined-based headline inflation measure appears to be the most feasible and appropriate measure of inflation as the closest proxy of a true cost of living index-for the conduct of monetary policy. Thus, the Urjit Patel committee recommended that the RBI should adopt the new CPI as the measure of the nominal anchor for policy communication, as the majority of Indians' spending basket comprised food items. Wholesale Price Index was rejected since manufacturing items as such did not touch the common man.
CPI for December 2019 climbed to 7.35 per cent; highest since 2014. Along with this, the statistical office has been projecting the economy to expand at just 5% for the current fiscal year; lowest in last 11 years. Now, using CPI, within which food items constitutes the main component, a substantial part of the CPI inflation may not be in the ambit of monetary policy to control while the exclusion of food and energy may not yield ‘true’ measure of inflation for conducting monetary policy. Monetary policy impacts demand and that too of industrial goods and services but not food prices.
Monetary policy impacts demand and that too of industrial goods and services but not food prices. (Photo: PTI)
Apparently, the increase in food prices are majorly pocketed by middlemen, which come under the category of services. This is a great irony that the agriculture sector is not reaping the gains of increased prices. What is urgently required is reforming the agriculture sector and unless this is done, the MP may not achieve its objectives. According to Governor Das, the average share of farmers in retail prices of major primary food items vary between 28 per cent and 78 per cent; the lower for perishables and the higher limit for non-perishable items.
Second, MP is inherently a medium-term framework because of the long and variable lags in its transmission. As there is a time lag between the implementation of the monetary policy and its visible impact, it generally results in ambiguous perceptions of the policy stance of the country’s Central Bank. Another factor to be taken into account is the instability imparted to output and employment due to the continuous emphasis on achieving the inflation target, which spills into losses associated with deflation. This is presently what the Indian economy seems to have entered into.
Covid-19 and the monetary policy’s new normal
With the outbreak of the Covid-19 pandemic, the RBI has proactively worked towards aligning the monetary policy. It has in the last few weeks taken bold decisions to maintain higher liquidity with the banks and tried to ease the market situation by directing the lenders (on March 27, 2020) to give an option to their borrowers to defer their loan repayments for three months. The monetary policymakers are sympathetic to the unprecedented times where the economy has come to a near halt. They have taken a series of measures like lowering repo and reverse repo rate so that the banks don’t park funds and the investment climate can be kickstarted.
Currently, oil prices have fallen to an all-time low, which means the inflation too should plummet, given the weightage of oil in CPI. However, it cannot be debunked that the economy will have logistical constraints in transporting essential supplies, which may result in food inflation. CPI will eventually get affected by the forestated two factors, but the task of monetary policy in current times is to provide liquidity to the economy and prioritise growth.
The suggestions are strong that the RBI may recourse to debt monetisation to achieve the growth agenda, as the fiscal deficit for the current financial year will be far higher than originally budgeted. If this deficit is financed by markets, then it will lead to a sharp escalation in interest rates, which will further weaken the already-fragile financial market by adversely affecting the businesses and muted household financial savings. Hence, debt monetisation may appear as an alternative, which will certainly disturb India’s inflation-targeting framework, and perhaps question the effectiveness of the future monetary policy, but considering the present circumstances, it would be prudent not to emphasise IT as boosting the Indian economy with respect to investment and growth is a far greater imperative need.
It cannot be overruled that a ‘new normal’ in terms of central banks’ targets may have to be designed taking into account the implications of stopgap measures used to address the current health crisis in India.
(The authors acknowledge the support of Anushka Handa, DPS RK Puram, in articulating this piece.)