MPC members caution against post-Covid hysteresis

Two members of the six-member Monetary Policy Committee (MPC) have cautioned about ‘hysteresis’ in view of the pandemic-induced shock to the economy.

Member Chetan Ghate observed that Covid is simultaneously a negative demand and a negative supply shock. “Macro policy broadly must ensure that a temporary Covid type shock to the Indian economy does not become permanent,” he added.

“Economists call this hysteresis. In a post-Covid world, as Olivier Blanchard notes, hysteresis will be driven by human behaviour. Despite the economy opening up, people will still hesitate to go out and spend. This will limit the effects of unlocking the economy,” he said.

One member also warned that monetary policy, which in currently in an accommodative phase, will be constrained by mandate to undertake remedial action (read ‘hike repo rate’) if inflation persists above the upper tolerance band for one more quarter, according to the minutes of the MPC meeting released by the RBI.

All MPC members unanimously voted to keep the policy repo rate unchanged at 4 per cent at the meeting held from August 4 to 6, in view of rising inflationary pressures.

The August MPC meeting was the last one for external members Ghate, Professor, Indian Statistical Institute; Pami Dua, former Director, Delhi School of Economics; and Ravindra H Dholakia, former Professor, IIM-Ahmedabad, who had been appointed to the committee for a four year term in 2016.

Michael D Patra, Deputy Governor, underscored that at the current juncture, with inflation prints above the upper tolerance band, technical considerations under the monetary policy framework warrant a preoccupation with dealing with the conditions of failure. “All this, after a period of four years of uninterrupted success in keeping inflation well within the tolerance band and, in fact, closely aligned with the target, which has earned the country credibility in monetary policy conduct, investor confidence and the anchoring of expectations!

“Consequently, monetary policy is forced into a standstill even when there is space available to persevere with its commitment to reinvigorate growth momentum and alleviate the effects of Covid-19,” he said.

In fact, if inflation persists above the upper tolerance band for one more quarter, he warned, monetary policy will be constrained by mandate to undertake remedial action, including an immediate and more than proportionate response to head off the build-up of inflation pressures and prevent it from getting generalised.

“The question is: can the economy withstand it in this virus-ravaged, debilitated state? The MPC has already signalled its concern in its stance by resolving to ensure that inflation remains within the target going forward.” Patra said.

He assessed that the outlook is grim; even when it improves, the expectation is one of slow, hesitant recovery, with the situation likely to worsen before it gets better.

Patra underscored that the urgency of unshackling monetary policy from extraneous non-pandemic constraints, emerging out of inadequate and lagged reactions in terms of supply management.

“In the absence of this coordinated strategy, monetary policy will be left with no option but to adhere to its primary mandate of the MPC, which is after all, achieving the medium-term target for consumer price index (CPI) inflation of 4 per cent within a band of +/- 2 per cent, while supporting growth,” he said.

Das speak

RBI Governor Shaktikanta Das said the generalised inflationary pressures across food and CPI excluding food and fuel, in a situation where growth is expected to contract sharply, is a matter of serious concern.

Although there is headroom for further monetary policy action, Das felt that at this juncture it is important to keep the RBI’s arsenal dry and use it judiciously.

“I also feel that we should wait for some more time for the cumulative 250 basis points reduction in policy rate since February 2019 to seep into the financial system and further reduce interest rates and spreads. Given the uncertain inflation outlook, we have to remain watchful to see that the momentum in inflation does not get entrenched, which is also dependent on effective supply-side measures,” Das said.

Use the crisis

Ghate felt that this should be a crisis that is not wasted. He emphasised that the government must continue to focus on much needed structural reforms. Some fiscal space should be reserved for later outbreaks.

Mridul K Saggar, Executive Director, RBI, observed that the disruption caused by the pandemic will leave hysteresis, implying some permanent damage to potential output even after pandemic recedes, although speedy policy action has contained this impairment. In these circumstances, the MPC has been rightfully mindful of growth as well within the flexible inflation targeting framework. It has taken actions with a view to prevent output collapse that could otherwise have had lasting impact, he said.

Saggar said: “Inflation statistics in the pandemic period have elements of fuzziness…Growth is at risk over the medium term if we sacrifice macro-financial stability for short-run expediency. Moreover, there is sound rationale that monetary policymakers should do less under uncertainty.”

Pami Dua noted that it is important to revive the economy and mitigate the impact of the pandemic, in line with the objective of monetary policy.

“It is thus prudent to continue with the accommodative stance of monetary policy…However, at the present juncture, the outlook for inflation is also uncertain, with risks more on the upside. Some clarity is also required with respect to the imputation of the April and May prints..Considering the above factors, at this juncture, it is best to adopt a wait and watch strategy and look forward to incoming data to assess the evolving macroeconomic situation.,” she said.

Ravindra H Dholakia said he has strong reservations in accepting the implicit inflation numbers for April and May announced by the NSO.

“I would, therefore, like to wait and watch for more reliable and realistic estimates of the headline inflation before taking any decision on the policy rate. I vote for status quo both on the policy repo rate and the stance,” he added.

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