Monetary policy is not a panacea

The monetary policy and associated statements and documents announced on Thursday (Aug. 06) unfold uncertainties that can’t be modelled, upsides risks to inflation and an anaemic global growth outlook in the midst of unrelenting havoc caused by the Sars-Cov-2 pandemic. What can the monetary policy hope to do in the given circumstances?

In some senses, the monetary policy has lost its relevance as the potent tool (at least in theory) of lowering interest rates coupled with printing money to boost aggregate demand and can be played only thus far and no further. The Indian economy is currently seized with the threat of a stagflation-like (recession accompanied by inflation) situation. In this scenario, one can only sympathise with the RBI Governor when he says, as he did on Thursday: “I am an eternal optimist.” When the car stalls, the tools don’t work and there is nothing else in sight, there is a choice between optimism and pessimism, and the former is better than the latter! This is significant and it points to the limitations of the monetary policy at a time like this.

The Indian economy is currently seized with the threat of a stagflation-like (recession accompanied by inflation) situation.

This is the third monetary policy committee (MPC) resolution since the pandemic struck. This time, the MPC unanimously voted for no change in the overnight policy repo rate (the rate at which RBI injects liquidity in the system and also gives some signaling of short-term interest rate in the economy) primarily because of uncertainty accompanied by upward risks to the inflation outlook.

During the previous two resolutions, both of which were off cycle ones (held before the stipulated dates), for urgent policy action, the policy repo rate was lowered cumulatively by 115 basis points to boost aggregate demand in the economy through higher investment and consumption. Thus, the MPC front loaded the reduction in interest rates.

But the Indian economy has entered a “contractionary phase” and this will continue for some more time. Though RBI has been silent on the magnitude of the contraction, we have the IMF, the World Bank and many research organisations and analysts offering a view -- they see the decline in growth of the Indian economy in the range of 3 to 6 per cent. If these numbers hold, we are in for the highest contraction we would have seen since Independence.

Unlike advanced economies, where inflation remains subdued, Inflation in India is under pressure as the retail inflation measured in terms of Consumer Price Index, CPI, has continuously remained above the ceiling level of 6 per cent. This is above the upper limit of tolerance under the inflation targeting approach which mandates that the MPC works to maintain average inflation of 4 per cent (+/- 2 percentage points). We have this breach of the upper limit for three consecutive months beginning April 2020 both in the food and non- food segment. The critical aspect is revival of non-inflationary growth, implying that retail inflation should be maintained at 4 per cent and at the same time the Indian economy should be revived from its contractionary/recessionary trend.

Unless a reverse migration takes place, industrial revival looks difficult.

Another aspect which is highlighted in the Governor’s statement on Aug. 06 is the lowering of interest rates in various segments of the financial markets, including the corporate bond market. The lower interest rate as observed in the financial sector and the corporate sector is primarily on account of lower interest rates in the government bond market, which is technically a bench mark rate for the other rates. The lower interest rate in government bonds is on account of a large amount of liquidity (which is actually injecting cash in the system).

Now the question is that a large amount of cash has already been injected by the RBI into the banking system, which in turn has financed government borrowing, because tax collections have collapsed and the government deficit has gone up. It is important to note that any cash injection has a potential of inflation as it will fuel consumption. Any growth led by government consumption expenditure, leading to private consumption is not sustainable as it has the potential of inflation. More importantly, currently, production is not taking place because of a lockdown in many parts of the country and social distancing.

Already RBI has taken recourse to a front-loading approach.  There has already been a reduction of 250 basis points in the policy repo rate since February 2019 till date. As per the Governor’s statement, only a 162 basis points reduction has taken place in the fresh lending rates. More importantly, even if the rate has been reduced, credit growth has not been taking place at a higher rate because of the given uncertainty.

Another related problem is the issue of migrant labour related to the industrial sector.   Unless a reverse migration takes place, industrial revival looks difficult. As regards the monsoon and kharif crop, there are problems of flood and no adequate rain in Eastern India. Therefore, in the current milieu, there are uncertainties in agricultural production also.

To conclude, the monetary policy as an arm of economic policy mostly addresses the downturn of a business cycle.  The contractionary phase in the Indian economy which is accompanied by higher than the targeted retail inflation is not a normal business cycle phenomenon.

It is due to a lockdown, social distancing and disruptions in the supply chain.  Thus, while the monetary policy by reducing interest rates or printing money could have some space in advanced economies to revive the economy, there is very limited space in India as the potential threat of inflation looms large.

(Dr. R K Pattnaik is a former Central banker and a faculty member at SPJIMR)