A heretic's view of India monetary policy

 (A version of the enclosed article appeared in Mint, per link below:

https://www.livemint.com/opinion/columns/a-nuanced-monetary-policy-in-a-very-complex-context-11649612421576.html )

A tough context

 

Between the scars of the pandemic and the challenges from the Russia-Ukraine conflict, our economic context is a policymaker’s nightmare.

 

Two years on, economic activity is barely at pre-pandemic levels. Within this, larger companies have done well with increased formalization, even as small businesses have struggled. While contact-based services should now resume, the global backdrop continues to cloud our recovery.

 

Despite anemic growth, CPI inflation has averaged 6.0% over two years, and inflation expectations are in double-digits. Given commodity prices and disrupted supply chains, CPI inflation could well exceed 6.0% during fiscal year 2022-23 (FY23) as well.

 

On employment, notwithstanding shortages in skilled labor, Center for Monitoring Indian Economy (CMIE) suggests that India lost 2 crore non-agricultural jobs over the last five years. 

 

There are some silver linings in our fiscal and external balance. While fiscal deficits remain high, tax collections are set to exceed targets. Likewise, while crude oil prices could push FY23 current account deficit to over USD 100 billion, RBI’s FX buffers offers us comfort for now.

 

India’s flexible inflation targeting framework – a critique

 

As the last two decades have demonstrated, macroeconomics is complicated. There are dynamic inter-relationships between growth, employment, inflation, fiscal balance, external balance, and financial stability. Each of these are in turn impacted by interest rates (the short-end, the long-end, and everything in between), banking liquidity, fiscal choices, exchange rates, macroprudential regulations, RBI interventions, and sentiments. 

 

We feared that acknowledging these complications could allow the government of the day to arm-twist policy makers to deliver whatever they wanted, taking refuge under this complexity.

 

To address this, the RBI act was amended to introduce a Monetary Policy Committee (MPC), now charged with keeping CPI inflation between 2% and 6%, by setting the policy (repo) rate. 

 

The setting up of MPC is laudable, as is its clear mandate to control inflation. However, the law also wishes away complexity, by simplistically implying that changes to the policy repo rate alone can bound India’s CPI. 

 

Mainstream dogma now suggests that if inflation is up, repo rate must be increased – and anyone suggesting a more nuanced analysis is a heretic. 

 

A heretic's view of monetary policy

 

How should monetary policy now control inflation?

 

Over a two-year period, credit growth is barely at 7.5% per annum, lower than nominal GDP growth, while credit to deposit ratio is at just 54%. There is little to suggest, yet, that low short-end rates are feeding inflation via credit growth. In fact, more money has been created by fiscal deficits and foreign exchange inflows, than by credit growth.

 

However, the possible indirect impact of repressed interest rates on asset prices and inflation cannot be denied. Against 3-month ahead household inflation expectations of 11.1%, weighted average fixed deposit rates are at 5.0%. Given large negative real interest rates, savers are forced into riskier asset classes. Mutual funds saw a record INR 4 lakh crores of inflows into risk-seeking schemes in FY22, nearly thrice the INR 1.4 lakh crores of equity outflows from foreign investors. This also explains the resilience of our markets. Similarly, we saw record USD 50 billion of net gold and jewelry imports in 2021, and a spike in demand for luxury items. 

 

Finally, there is also sentiment. In the February policy, MPC had projected average FY23 CPI inflation at 4.5%, much lower than analyst estimates. To manage both inflation expectations and foreign investor sentiment, it is important to preserve policy credibility.

Given this backdrop, the RBI and MPC deserve credit for their announcements last week. By placing inflation before growth, and by raising FY23 CPI estimates to 5.7%, the MPC has strengthened policy credibility. Separately, notwithstanding arguments around public good, 10-year GOI bond yields have been allowed up from 6.0% last year to over 7.0% now. Higher returns for long-term savers can help address rising inequity and inflation. At the same time, RBI and MPC will hopefully refrain from rushing in to raise short-term rates, until signs of excessive credit growth emerge. Much of our investment-oriented loans (including mortgages), much-needed for jobs and output growth, are still linked to short-term rates. 

 

Hopefully, the RBI will continue to shun dogmas, while preserving credibility. 

 

Bottomline

 

While we spend immense time debating monetary policy, it is the real economy that ultimately matters. China did not become a powerhouse because of its monetary policy framework – it created enough jobs, output, and exports, to make monetary policy redundant. We would be well advised to do the same.