Restoring balance in monetary policy

Since 2011 the RBI has been on a path of structural reform. But now that inflation is in the target band and growth is slowing, it is possible to think of countercyclical monetary policy; and since credit growth is slowing it is possible to think of countercyclical regulatory policy. The RBI was a pioneer the latter before the global financial crisis (GFC) but has now fallen behind.

The aim of an inflation targeting regime is to anchor inflation expectations so that monetary policy can be countercyclical as prices then respond less to commodity price shocks. Research shows there is some success in anchoring expectations. Headline inflation has been below the RBI target for long, and now there is a sharp fall also in core inflation, which was sticky earlier.

Headline is rising but is likely to stay below the target of 4 per cent, while core falls towards 4 per cent. That core inflation was sticky for long should not be attributed to excess demand raising wages since employment growth was slow. The latter itself should have reduced core inflation earlier but did not. It is more likely the fall now is due to reduction in inflation expectations, which fell with a lag.

The RBI no longer needs to continue with the monetarist-finance view that has dominated since 2014. In this view macroeconomic stimulus cannot affect employment, markets left largely to themselves achieve the best outcome, structural reforms’ only aim is to unfetter markets, while subjecting them to market discipline. This stance is at odds with the current dominant global thinking after the GFC, and with the flexible inflation targeting framework RBI is itself following.

The thinking in Europe was that austerity will increase growth; the US went in for stimulus and has done much better. But we are persisting on the austerity path even as we see growth slowing and financial stress rising. It is time to move to more balance.

After the elections

Private investment growth has stagnated since 2011. There was a brief recovery of animal spirits after the last election, but thanks to the highest real interest rates ever seen in India (as inflation fell with oil prices, but nominal interest rates were not adequately lowered), as well as the asset quality review (AQR), bank lending to firms turned negative and squeezed out the revival. Something similar should not happen this time.

It can be argued that as election uncertainty dissipates private investment will revive and foreign money will pour in. But growth has been softening for many months now in a period of rising real interest and tight liquidity. There are external shocks also from the global slowdown and trade wars.

Policy response

Many indicators suggest the fall in consumption growth, and therefore in investment may persist in the absence of a policy response. In mid-May the one-year GOI Treasury bill rate was 6.5 per cent. With the inflation forecast at 4 per cent or below, one year ahead real interest rate is above 2.5 — the highest in the world.

Since the neutral real rate is about 1 per cent there is space to cut policy rates by 1.5 percentage points. Can policy afford to be this tight when growth is slowing and inflation is in the target band? Counter-cyclical stabilisation is the dharma of inflation targeting. Even if the MPC resorts only to a 0.25 percentage point cut now, waiting for the Budget and the monsoon to play out, there are ways the RBI can improve transmission. It can communicate a softening stance and act on liquidity to reduce market rates, reducing rising spreads for borrowers.

Long and variable lags are used to justify setting policy rates based on inflation forecasts — but it is necessary to distinguish between the extent of backward (BL) and forward looking (FL) behaviour. If FL dominates, a sharp response to expected inflation reduces the cost of disinflation.

But with a large share of BL behaviour, instability can occur — the response should be small but quick, while communication on future moves guides those who look forward. Uncertainty and waiting for new data also justifies such a response. To the extent expectations are anchored, response to signs of slowdown has to be faster while transient price shocks are looked through.

Even if the MPC does not shift to accommodation, other communication can convey softening. Allowing real rates to reach 3-4 per cent in 2014-15 was an over-reaction that caused a lot of instability and damage in the economy.

Liquidity factor

The composition of liquidity also matters. Although the RBI is now keeping short-term liquidity in surplus, banks scarred by a long battle with NPAs are just parking it back with the RBI, instead of increasing lending. M3 and credit growth rate are low. If the share of durable liquidity is increased it will encourage banks to lend and also reduce market rates.

It is necessary to take prompt action against the ongoing stress in NBFCs since it is causing escalating spillovers.

The RBI did not want to open a special liquidity window because of credit risk — the view was that exit of weaker NBFCs would create better incentives.

The RBI did make it easier for banks to refinance NBFCs, but they are not doing so, since they are also afraid of credit risk arising from systemic effects. Bank lending has improved as that from NBFCs reduced, but not enough. Even the better NBFCs, in the current environment, are hoarding liquidity and lending less.

Since measures taken so far have turned out to be inadequate, more needs to be done.

Apart from an overall rise in liquidity, a temporary window for NBFCs that makes liquidity available at high rates and good collateral would not be used much, but may build confidence and increase lending.

In the long term reforms must make regulations uniform so that different financial entities grow complementing each other, rather than arbitraging regulations. But an asset-liability mismatch should not be allowed to drive potentially solvent but illiquid institutions into bankruptcy.

An NBFC AQR now would be procyclical — the bank AQR killed lending to industry for many years.

The government may complement these reforms with a fuller recap of banks, which is possible now with bankruptcy and some governance reforms in place, even as the returning government is likely to renew its commitment to fiscal consolidation, sustaining the space for monetary stimuli.

The writer is Professor at IGIDR; and Member, EAC-PM

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