Has the monetary policy been effective?

Some clear and telling signals stand out from the Monetary Policy Committee (MPC) resolution released Wednesday, along with the attendant material in the RBI Governor’s statement and the Governor’s press conference.  In the present milieu, there are indications of economic recovery but growth is not strong enough to be seen as self-sustaining and durable. Weak private investment and private consumption continues to be a drag on the revival of aggregate demand and thus growth. Further, persistence of core inflation (headline CPI inflation excluding food and fuel) and its transmission to headline retail inflation has become a serious policy concern.

The negative output gap (actual output minus potential output) is likely to be prolonged and is a dampener for growth, particularly in the light of growth–inflation tradeoffs that are coming into play. There are new questions on rebalancing of surplus liquidity. And all of this plays out amid adverse global developments on growth and inflation as a result of the continued risk from the pandemic, particularly newer variants like Omicron, and the possible spillovers to Indian economy. These developments raise some questions regarding the capacity and efficacy of the monetary policy to meet its dual mandate of price stability and growth.

Low interest rates haven’t helped spur private investment and consumption, and inflation risks continue

The monetary policy resolution of December 08, 2021 (voted unanimously) to maintain status quo on the three key interest rates viz; policy repo rate (PRR) at 4 per cent, reverse repo rate (RRR) at 3.35 per cent and marginal standing facility (MSF) at 4.25 per cent under liquidity adjustment facility (LAF). This was as widely expected. The policy continued with the accommodative policy stance (with a 5:1 vote) in the current situation, where the balance of the growth–inflation dynamic has tilted more towards growth. This is given the rough ride because of the pandemic, and is consistent with the overarching objective of the RBI to maintain price stability keeping in mind growth.  

To achieve this objective on a durable basis, it needs to be pointed out that interest rate reduction and transmission of the same to bank lending rates is a necessary condition but not a sufficient condition to drive growth. The sufficient condition is credit off-take by the private sector, which continues to be poor in the current circumstances and is a red flag for growth revival in the medium and longer term.

A glance at the data released in the monetary policy report (October 08, 2021) reveals that in response to reduction in the policy repo rate by 250 basis points(bps) during February 2019 to September 2021, the weighted average lending rate by banks were reduced by 190 bps for fresh loans and 118 bps for outstanding loans. In terms of the marginal cost lending rate (MCLR) by the banks (as per the data released by the RBI), the rate reduction was only 10 basis points.

For example, as on November 26, 2021, the MCLR was within the range of 6.5 and 7.0 per cent as compared with 6.60 and 7.10 per cent as on November 27, 2020. Furthermore, as per the data released by RBI, the deployment of credit by the banks recorded an increase of a meagre 0.8 percent on a financial year basis (October 22, 2021 over March 26 2021). The credit off-take witnessed contractions during the above period in respect of large industries (4.4 per cent) and services (1.6 per cent). Weak credit off-take along with hesitant transmission of interest rate reduction to bank lending rate reduction does not augur well for a strong durable and self-sustaining economic growth. This, in turn, results in the continuation of a negative output gap.

Let us now turn to inflation. The inflation outlook measured in terms of CPI (combined) as set out in the MPC resolution for 2021-22 is at 5.3 per cent and around 5 per cent in Q1 and Q2 of 2021-23. It is pertinent to mention that while commenting upon core inflation, the MPC resolution mentioned that “cost-push pressures from high industrial raw material prices, transportation costs, and global logistics and supply chain bottlenecks continue to impinge on core inflation.”  Even though crude oil prices have shown some contraction, the market remains volatile. The untimely rain in Eastern India has adversely impacted kharif crop harvesting.  There are signs of uptick in tomato and onion prices.  On the whole, there could be some pressure on food inflation.

Another important aspect is liquidity management by RBI. The RBI, henceforth (beginning January 2022), will move to reverse repo through auction route in terms of Variable Rate Reverse Repo (VRRR) with longer term maturities of 14 days and 28 days to manage the surplus liquidity. This will be in a non-disruptive manner and will give flexibility to the RBI to manage the size and maturity of the reverse repo. The overnight policy repo rate in the LAF framework has already been discontinued. Now, it looks like the fixed rate reverse repo will be discontinued gradually. Thus, the injection and absorption of liquidity in the LAF framework will be addressed only in terms of the rate variable (interest rate on PRR and RRR) and not by the size or magnitude of liquidity. This will be a significant change in that it gives the RBI more flexibility in liquidity management. 

Credit off-take by the private sector continues to be poor and is a red flag for growth revival in the medium and longer term

RBI has already been on the pause mode in the policy rate (kept at 4 percent since May 2020) and in maintaining an accommodative stance also. To a greater extent, the monetary policy has been front loaded with the injection of liquidity (around 8.7 per cent of GDP) to address issues relating to the transmission of monetary policy to bank credit and also to finance the market borrowing programme of the government. However, of late, the yield on the 10–year government bond has shown increases. For example, it was 6.34 per cent as on November 26, 2021 as against 5.84 per cent as on November 27 2020. This firming of rates may jeopardise the transmission of monetary policy.

In the end, it may be concluded that a lower interest regime is a tool that has not helped, neither in terms of transmission fully nor in the credit off-take and private investment and consumption. Inflation risks continue. Global developments have turned adverse. All of these raise the all- important question: Has the monetary policy really been effective? The bigger question therefore is: How long will the monetary policy be on the beaten track?

(The writer is a former central banker and a faculty member at SPJIMR. Views are personal)