A complex monetary policy, in a very complex context

Despite the anemic growth, the consumer price index (CPI) has averaged 6% over two years, and inflation expectations are in the double digits. Taking into account commodity prices and disrupted supply chains, the CPI may exceed 6% in FY13.

On employment, despite the shortage of skilled workers, the Center for Monitoring Indian Economy (CMIE) suggests that India has lost 20 million jobs in the last five years.

There is some hope in our financial and external balances. While the fiscal deficit remains high, tax collections are bound to exceed the target. Similarly, while crude oil prices may widen the FY23 current account deficit to over $100 billion, the Reserve Bank of India’s (RBI) forex buffer gives us comfort for now.

As the past two decades have demonstrated, macroeconomics is complex. There are dynamic inter-relationships between growth, employment, inflation, fiscal balance, external balance and financial stability. Each of these is influenced by interest rates (short-end, long-end, and everything in between), banking liquidity, fiscal options, exchange rates, macroprudential regulations, RBI intervention, and sentiment. We feared that accepting these complexities might allow the government of the time to deliver whatever they wanted, while taking refuge under this complexity.

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

The establishment of the MPC is laudable, as is its clear mandate to control inflation. However, the law also seeks to remove the complexity, simply by saying that only a change in the policy repo rate can bind India’s CPI. Mainstream dogma now suggests that if inflation is rising, the repo rate should be increased – and anyone suggesting a more nuanced analysis is a heretic.

How should monetary policy now control inflation? Over the two-year period, credit growth is barely 7.5% per annum, which is less than nominal gross domestic product (GDP) growth, while the credit to deposits ratio is just 54%. There is little to suggest, however, that low short-end rates are feeding inflation through credit growth. In fact, fiscal deficit and foreign exchange inflows have created more wealth, not credit growth.

However, the possible indirect impact of suppressed interest rates on asset prices and inflation cannot be ruled out. Against three-month forward domestic inflation expectations of 11.1%, weighted average fixed deposit rates are at 5%. Given large negative real interest rates, savers are forced into riskier asset classes. Mutual funds saw record 4 trillion inflows into risk-taking schemes in FY12, nearly tripled 1.4 trillion equity outflow from foreign investors. It also explains the resilience of our markets. Similarly, we saw a record $50 billion net gold and jewelery imports in 2021 and an increase in demand for luxury goods. Lastly, there is value. In the February policy, the MPC had projected average FY23 CPI inflation at 4.5%, much lower than analysts’ estimates. To manage both inflationary expectations and foreign investor sentiment, maintaining policy credibility is critical.

Against this background, RBI and MPC deserve credit for their announcements last week. By putting inflation ahead of growth, and raising FY23 CPI estimates to 5.7%, the MPC has strengthened policy credibility. Separately, the 10-year GOI bond yield has been allowed to increase from 6% last year to over 7% now, notwithstanding public good arguments. Higher returns for long-term savers can help address rising inequality and inflation. At the same time, it is expected that the RBI and MPC will refrain from rushing to hike short-term rates, unless signs of excessive credit growth emerge. Most of our investment-oriented debt (including mortgages), much needed for jobs and production growth, is still tied to short-term rates. The RBI is expected to continue to shun dogma while maintaining credibility.

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

Anant Narayan is Associate Professor at SP Jain Institute of Management and Research.