Monetary Policy: Just flawed logic or toeing FM’s line?
The bimonthly Monetary Policy Committee (MPC) meeting in December saw members take a cautious path. All members except Professor Jayanth Varma voted to maintain the status quo on policy rates and an accommodating stance to support the economic recovery while controlling inflation – a strategy that has remained unchanged for more than a year now. The question is: has monetary policy achieved the desired short-term objective?
Monetary policy, by regulating key rates and therefore money supply, liquidity and the line of credit, should strike a delicate balance between inflation and economic growth, variables which are considered to be inversely related, according to supporters of the very famous Phillips curve hypothesis. . Monetary authorities are increasing the money supply – monetary easing – to stimulate economic growth, while providing space for price increases, and reducing the money supply – monetary tightening – to control inflation, while undermining economic growth. The MPC is mandated to recommend key rates based on these theoretical concepts.
Policy rates under the MPC include the repo rate, the repo rate, the permanent marginal facility (MSF) rate, and the bank rate. The reverse repo rate is the rate at which the RBI lends to banks overnight in order to have liquidity to manage regulatory requirements. The reverse repo rate is the rate at which banks lend to the RBI overnight when the RBI is required to absorb liquidity. The MSF rate is the overnight borrowing rate from the statutory liquidity portfolio in order to benefit from a safety valve against unforeseen liquidity shocks.
Monetary theory postulates that these rates control the speed of money – the rate at which money changes hands. Controlling speed can have an impact on the balance between inflation and growth. In this context, previous MPC resolutions recommended a cut in key rates and proposed an accommodative stance since August 2019 to stimulate the economy, albeit at the expense of inflation.
At the recent meeting, the MPC observed a widespread recovery as all constituents of aggregate demand show expansionary traits. Yet the relevant question is: was monetary policy responsible for this “perceived” recovery? The answer is: Negative!
The resilience of rural demand and the reduction in dependence on MGNREGA can be attributed respectively to direct transfers from the PM-Kisan regime and the resumption of the rabi sowing season. Many of these unorganized sector economic activities are assumed to be sensitive to changes in policy rates, an assumption that is far from the truth. In contrast, investments, auto sales, steel consumption and high-frequency interest rate-sensitive indicators showed only modest improvement, according to the MPC resolution, raising questions about the role and effectiveness of monetary policy.
On inflation, the MPC’s resolution suggested that headline and core inflation face upward pressure. Irregular rains damaged crops and increased uncertainty about the harvest planned for January, putting upward pressure on food prices. In addition, efforts to mitigate the pass-through of rising global fuel prices have had limited success. All of this can cause production costs to rise, leading to sectoral and headline inflation. Signs are visible, with wholesale price inflation reaching 14% in November 2021. Wholesale price inflation is set to trickle down to retail prices over time. Yet the committee appears to have completely overlooked the threat of a pass-through of inflation from wholesale prices to retail prices, which will ultimately burn a hole in the pocket of the common man.
Another area of concern is inflation in advanced and other emerging economies. Policy makers in these economies have resorted to monetary tightening. With interest rates in India lower than world rates, capital outflows will become inevitable. In addition, global inflation will also lead to an increase in import bills relative to exports, leading to an increase in the trade deficit. These aspects will increase the supply of the rupee in the foreign exchange markets and cause the currency to depreciate. While these aspects largely fall within the remit of the monetary authorities, has the MPC done enough to address them?
Other concerns hint at the large excess in liquidity conditions. The surge in liquidity will lead to a situation where too much money will chase out too few goods, causing inflationary pressures in the economy. As the RBI tries to mop up liquidity through fixed rate and floating rate reverse repurchases, is it too little or too late?
These findings raise major questions about the approach followed by the MPC. Is the MPC following the line of the Ministry of Finance in giving way to an expansionary fiscal policy due to the elections to the Assembly? Or, is the committee simply pursuing faulty logic?
(The writer is professor, School of Liberal Arts, Alliance University, Bengaluru)
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