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Towards a Sustainable Monetary Policy

Recently there has been much discussion in public fora on the RBI losing control over inflation. Latest figures for May, 2022 are alarming at15.88 percent for WPI (wholesale price index) and 8.3 percent for CPI (consumer price index). This has lowered real returns and severely dampened external markets with the Dollar-Rupee exchange rate touching a historical low of Rs. 80 per dollar.

India’s monetary policy (MP) by and large has remained accommodative in wake of the COVID-19 Pandemic especially, to support investment and growth (the repo rate, brought down from 5.15 percent in March, 2020, was raised once again only in May, 2022 to 4.4 percent). Proponents of inflation control have been extremely critical of the central bank’s delay in responding to surging inflation and avoiding a rate hike until recently on June 8, 2022. Arvind Subramanian and Josh Felman (The Indian Express, 15th June, 2022), have even blamed the RBI for falling behind the inflation curve, as it has consistently missed the 4 per cent inflation target for the past three years, since October 2019 and for few of the months even tolerated a breach of its upper limit of 6 percent. It has been described as a failure of the institution and its guardrail as, formally the RBI is an inflation targeting Central Bank. Such laxity may be harmful as the economy may fall into the trap of rising inflationary expectations. Is it that the RBI is now keeping its inflation objective second to growth?

The Rajan years (Raghuram Rajan was RBI Governor September, 2013 to September, 2016) saw the RBI adopt a prolonged hawkish stance to counter inflation. For current RBI Governor Shaktikanta Das, it was a conscious decision to tolerate inflation up to 6 percent, which may have contributed to the better revival of our economy as compared to many others. As Monetary policy committee member Jayanth R Varma, puts it, the central bank is averse to taming inflation “too abruptly” and keen to avoid any “intolerable growth sacrifice”.

In-depth understanding of the objectives, priorities and options before the RBI calls for further discussion on pros and cons of inflation targeting vis a vis alternative options, as also the history of monetary policy-making in India.

Indian monetary policy has indeed evolved over time. In the initial post-independence years, monetary authorities functioned more or less as an arm of the Government that was entrusted with the task of financing the fiscal deficit. In 1985, for the first time, the landmark Sukhamoy Chakraborty Committee proposed the idea of working with an intermediate target, the quantum of aggregate money supply (M3). However, M3 did not prove to be a reliable target; as the era of economic reforms dawned from the 1980s, the money demand function became highly unstable. Later in 1998, RBI Governor C. Rangarajan implemented the Multiple Indicator Approach (MIA) under which several key macroeconomic variables such as interest rates, inflation, exchange rate, GDP growth, employment, foreign trade and capital flows, banking stability etc. were taken into consideration while crafting monetary policy. This provided monetary authorities flexibility to respond to changes in domestic and international economic and financial market conditions.

The economy responded well to MIA till the Global Financial Crisis of 2008, which saw large emerging economies like China, India and Brazil respond with a highly accommodative fiscal and monetary stance. This jeopardized inflation management by the RBI with both CPI and WPI slipping into double digits in 2009-10! As a result the RBI became hawkish and between March 2010 and October 2011 the repo rate was increased by 325 basis points (yet inflation increased from 10.88 in 2009-10 to 11.99 percent in 2010-11 before declining to 8.86 percent in 2011-12). Finally in May 2016, it formally adopted inflation-targeting (IT), the target being 4 percent rate of inflation, with a relaxation of 2 percent on both sides, in view of unforeseen macroeconomic shocks.

Research shows stable inflation is a prerequisite for sustainable economic growth. Controlling inflation reduces investor uncertainty, stabilises business sentiments, anchors inflationary expectations and helps to avoid large fluctuations in exchange rate and resultant foreign capital outflows. It reduces chances of a wage-price spiral as consumer and labour sentiments are anchored. Savers remain optimistic as real interest rates stay positive with inflation under control. Besides, high inflation imposes a tax, especially on the poor, as it adversely affects purchasing power, increasing inequality even further. IT makes the monetary authority accountable, bringing in greater transparency and policy-credibility. Even if inflation is due to supply shocks (such as the ones caused due to lockdowns during the Pandemic or, the Russia-Ukraine war), IT suppresses excessive demand, thereby curtailing at least one source of rising prices. Taming inflation is absolutely essential and should always lie ahead of the growth objective for the monetary authority.

Chasing inflation, it is argued, reduces capital investments by private firms, as high nominal interest rates raise borrowing costs. Consider the following pieces of empirical evidence for India : (a) till date pass through of repo rate changes to lending rates by the private banks is limited; (b) small and medium firms are largely reliant on internal funds and informal channels for finance – as such, changes in bank lending rates may have limited direct effects on investments by the MSME sector; (c) academic research shows weak operation of the interest rate channel (see Dastidar and Kaur, 2021) of monetary transmission.

In view of these factors, questions can be raised about the depth and intensity of negative growth effects of the RBI’s interest policy. Indeed, there has been a steady decline in capital expenditure plans of the Indian private corporate firms since 2010-11, with little signs of recovery even at present. As Dastidar and Ahuja (2019) show, a stable macroeconomic policy and business environment, external demand, real interest rates (shaped by expected inflation) and the pace of public investments are key factors affecting investments by the private businesses in India.

The RBI has adopted a prolonged accommodative monetary stance since March, 2020 to support weakening growth. With rising fuel and food prices and trade and supply shocks in the wake of the Russian invasion of Ukraine, inflationary pressures have only mounted amidst rising macroeconomic uncertainties, presenting a grim challenge for policy makers the world over.

The moot point now is does such a situation compromise the IT objective itself for the central bank? Is it reasonable to expect the RBI to remain committed to IT, in the face of severe macroeconomic turbulence? The discord between the inflation and growth objectives seems to threaten the very sustainability of inflation as a MP target. For emerging markets like India, does it not make sense for the central bank to factor in a larger number of economic concerns besides inflation? Indeed, the task for the RBI becomes far more complex and burdensome with the possibility of a K-shaped recovery and heightened global uncertainties in the wake of a rate hike by the Fed and likely onset of a recession in the US, however mild.

Whatever be the situation, inflation should be the utmost priority of the government. The time has come to supplement the central bank’s effort at IT, with determined efforts to address constraints especially in the agricultural supply chain, so as to ease pressures on domestic food prices. At the very least it would allow the RBI further leeway to act against inflationary impulses from fluctuations in global commodity prices and focus greater attention on exchange rate management and policy impacts on foreign capital flows.

Article By

Kajleen Kaur and Ananya Ghosh Dastidar

Kajleen Kaur is an assistant professor in economics at Sri Guru Gobind Singh College of Commerce, University of Delhi and Ananya Ghosh Dastidar is a professor at the Department of Finance and Business Economics, University of Delhi

Article Published By Nitin Naresh



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