The boundary conditions given to the Monetary Policy Committee under the inflation targeting framework stand violated as the calendar year draws to a close. Further, the limits will be just about under the upper boundary as the fiscal year ends in March 2021. Under the current policy, the MPC is tasked with keeping the inflation (CPI-C, or Consumer Price Index-Combined) around an average of 4 per cent within a band that varies from 2 per cent to 6 per cent — that is, up or down 2 per cent from the mean — while supporting growth.

The MPC resolution released on December 4 has projected the CPI inflation at 6.8 per cent for Q3:2020-21 and 5.8 per cent for Q4:2020-21. In this context it is important to mention that in March 2021, the legislative mandate explained above will come under review, and a new medium target is likely be announced by the Central Government.

Significantly, this time, the MPC resolution has recognised the importance of financial stability by stating that “monetary policy will monitor closely all threats to price stability to anchor broader macroeconomic and financial stability.” It is true that the MPC has not kept the inflation rate within its mandate as alluded to earlier. But these are unprecedented times, and the pandemic has brought challenges of the kind that no central banker could foresee.

Yet, any attempt to change the norms for inflation targeting should be resisted, even under special circumstances, given that keeping inflation under check has not been easy under the pressures and demands of the Indian system that is biased towards pushing growth at whatever cost, by lowering repo rates.

In these circumstances, how does the central bank and the MPC look at the prospect of driving sustainable, non-inflationary growth given the challenges — structural and short term — that pose a potent threat to the economy?

The GDP growth projection by MPC from a contraction of 7.5 during 2020-21 to a positive zone within a range of 6.5 per cent and 21.6 per cent in H1 of 2021-22 is largely due to the base effect. Therefore, the V-shaped recovery as projected by the MPC is more statistical in nature. This is discussed in the supply side and demand side analysis of economic growth.

Push and pull factors

It is pertinent to pronounce some of the push and pull factors for growth based on the narratives set out in the MPC resolution. Some of push factors are: (a) recovery in rural demand coupled with further momentum in urban demand as “unlocking spurs activity and employment”; (b) improvement in the business sentiment of manufacturing firms; (c) fiscal stimulus helpful for consumption coupled with consumer optimism; and (d) growth generating investment supported by liquidity injected by the RBI.

The pull factors, on the other hand, include: (a) slackening private investment; (b) feeble capacity utilisation; (c) uneven recovery of exports; and (d) subdued demand for contact-intensive services on account of social distancing and risk aversion.

The supply side growth is represented by Gross Value Added (GVA) with a decomposition of economic activity into agriculture, industry and services. According to Q2 data from the National Statistical Office (NSO), while the agriculture sector recorded a steady growth of 3.4 per cent, the services sector posted a contraction of 11.4 per cent.

However, the industrial sector showed improvements with a lower contraction of 2.1 per cent than the 38.1 per cent contraction in Q1.

So far, as the demand side is concerned, the GDP contracted at 7.5 per cent YoY in Q2 from a 23.9 per cent contraction in the previous quarter primarily led by a much more moderate contraction in investments and exports, partly compensating for a sharp drop in public and private consumption. Thus, going forward, recovery of growth from the supply side critically hinges on the contact driven services (like travel, tourism, hotels, theatre and entertainment industry) and further improvements in manufacturing.

From the demand side, growth recovery will depend on the improvement in investment, both private and government, and private consumption will lead growth revival.

Monetary policy intervention through interest rate reduction has yielded a negative real short term interest rate (difference between the policy repo rate 4 per cent and CPI inflation rate on an average in the neighbourhood of 7 per cent), coupled with large liquidity support from the RBI in turn have facilitated the lowering of long-term rates.

For example, a ten-year government bond rate was 5.84 per cent (November 27, 2020) as against 6.65 per cent (November 29, 2019). Similarly, the bank lending rate (marginal cost of funds based lending rate, or MCLR) has been lower at 6.60 per cent and 7.10 per cent than that 7.65 and 8.10 per cent during the same period as mentioned above. The large liquidity support by the RBI has facilitated the huge borrowing programme by the Centre and the States as they (together) mobilised ₹14,18,026 crore as on November 27, 2020, as against ₹8,84,827 crore as on November 29, 2019.

The moot question is even though growth will revive in 2020-21, how soon will it move to a higher trajectory and how soon will it be in the zone of non-inflationary sustainable levels.

The pandemic has posed a cyclical barrier to growth. But we have our underlying structural rigidities in terms of the transmission mechanism of monetary policy to credit channel coupled with the supply-side bottlenecks in enhancing productivity.

This requires higher investment relative to GDP supported by increased financial savings in the economy and augmentation of total factor productivity in terms of physical and human capital investment. That is the only path through which the MPC can live up to its declared priority of the monetary policy, which in its words is to “revive growth on a durable basis and mitigate the impact of Covid-19 on the economy, while ensuring that inflation remains within the target going forward.”

The writer is a former central banker and a faculty member at SPJIMR. Views are personal. Through The Billion Press