Ashima Goyal

Does monetary policy work in India?

ASHIMA GOYAL | Updated on November 18, 2013

Let’s hope the current vegetable price spikes are temporary.   -  PTI

As food inflation raises wages and forces monetary tightening, industry is squeezed from both sides.

It is a difficult task to bring down inflation at minimum possible cost to growth. The problem is even more acute in an economy already facing a negative output gap: actual output being less than what the economy can produce at full capacity. The growth sacrifice for even a small reduction in inflation on account of monetary tightening in this case can be very large.

How does monetary policy work in such conditions? It is often said that monetary tightening aims at anchoring inflation expectations. But a better understanding is required of exactly how expectations are formed in the larger economy beyond financial markets. If it is through reducing demand and creating a negative output gap, then the fact is that the gap has been negative for over two years now, but without denting expectations much.

In the current circumstances, what is the nominal variable best placed for reducing inflation and inflation expectations in India? Clearly, money itself is not so effective any longer since greater substitution possibilities make supply of money somewhat endogenous. The operative variable, therefore, is the interest rate or the cost of money, but this largely impacts the output gap, which is already negative.


The other nominal variables affecting inflation and formation of inflation expectations are supply shocks from oil or food prices, the exchange rate that affects these and other costs, fiscal deficit and government spending on domestic goods, and various infrastructure bottlenecks that prevent adequate supply response.

A persistent contribution of the above variables to inflation could be through second-round effects or multiple supply shocks. We have had all these in the last few years, leading to entrenched inflation expectations.

But thankfully, there are some hopeful trends of late.

To start with, we seem to be settling to some exchange rate stability around the ‘equilibrium’ real effective exchange rate. This reversal of excessive nominal depreciation that would have contributed to inflation, along with a clear reduction in the current account deficit, may help the economy to cope better with what is likely to be a gentler-than-feared US Fed taper.

Second, despite this being an election year, the government seems quite committed to meeting its fiscal deficit targets and like last year may cut fourth-quarter spending.

Third, we have seen only moderate increases in minimum support prices — again despite this being an election year.

Finally, rural nominal wage growth is down from 20 to 15 per cent, while in real terms, wages in August were up only 2 per cent year-on-year. Wages in the last few years were overcorrecting to steep food price increases, which again had major second-round effects on inflation. If the current vegetable price spikes are temporary, this in conjunction with the good monsoon and some softening of global food prices, can help bring about stability in real wages over the longer term.

But there are negatives as well.

The government, on its part, has no long-term strategy on tackling food inflation. Reducing excess policy focus on foodgrains and eliminating distortions in agricultural marketing are required to encourage crop diversification and meet changing consumer demand. Sectoral interaction and linkages cannot be ignored in India. As food inflation raises wages and forces monetary tightening, industry is squeezed from both sides. Thus, one sector throttles the rest of the economy.

There is some action on clearances for projects. But, clearly, much more needs to be done on this aspect of governance failure.


Given the above short-run positives, a neutral policy rate should be enough to anchor inflation expectations. The current repo rate appears to be close to it.

Research at the US Fed suggests potential output is endogenous. Monetary tightening should, therefore, take into account a possible destruction of potential output — of the kind India has experienced in the recent period as investment collapsed. But even so, there is still a 2-3 per cent negative output gap. This could compensate for headline or CPI core inflation that is 1-3 per cent above target.

Moreover, apart from rate hikes, we have also had liquidity tightening measures. These have pushed the operative interest rate far above the ‘neutral’ repo rate.

The shift to the marginal standing facility as the benchmark central rate has moved up the entire yield curve, not just its slope. All these — including higher borrowing costs for the government — represent long-term effects of what were supposed to be short term measures.

The liquidity tightening measures were aimed at stabilising the rupee. But event-based data analysis shows that what eventually worked, apart from a delay in US Fed taper, was the intelligent use of forex reserves. That included taking the oil marketing companies’ demand out of a fragile foreign exchange market. The use of interest rate defence and tightening only created unnecessary collateral damage.

The lessons for future ‘taper preparedness’ should be to focus on bolstering forex reserves as and when opportunities present themselves, reducing fiscal and current account deficits, and reviving growth. Reserves must be used to smooth demand and supply mismatches when uncertainty is high. Short-term foreign borrowings, which may have to be rolled over at a delicate time, should be avoided.


The best taper response today is to make the economy robust, not keep it and markets fragile through tight liquidity. There is reverse-disintermediation now happening since firms are finding it cheaper to borrow from banks rather than markets, although banks are passing on their higher cost of funds. Tight liquidity has forced the State Bank of India to stop discounting commercial bills other than those from the SBI group. There is a rise in hedging cost for small firms.

In the process, large shocks have been delivered to the system, whereas habitual central bank caution has preferred small steps in returning to normality. Such caution is more useful when there is market guidance along a path derived from a clear policy framework, which is not at present in place.

The gradualness may be worthwhile, moreover, if money markets are effectively deepened along the way, with a richer menu of instruments and trades. Term money markets have not developed in India despite past efforts. Rationing liquidity in different time buckets may help kick-start these markets.

Banks hold compulsory reserves or CRR above the required levels for fear of shortfalls. The mandated continuous level has now been raised to 95 per cent.

This can also drive banks to term money markets since in the Indian system sudden liquidity shortfalls occur due to rise in government cash balances or capital outflows.

(The author is Professor of Economics. IGIDR, Mumbai.)

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Published on November 18, 2013
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