Focus shifts to growth @ Mint Road : The Global ANALYST








Monetary Policy

Focus on Growth at Mint Road*

M G Warrier

Last month (TGA, June 2019), Madhusudhanan S concluded his article on Monetary Policy Committee  with this prophetic observation: “The MPC should not only look at inflation targeting as its only goal, but it should also use its Monetary Policy Framework to accommodate policy to ensure sustainable growth. As it is said, ‘Policy is meant for growth and not for impairment.’”
For sure, the above observation was recorded much before the MPC met between June 4 and 6, 2019 and RBI came out with a cut in base rate by 25 basis points simultaneously changing central bank’s policy stance from ‘neutral’ to ‘accommodative’. Just thought it appropriate to place on record that the time lag between analysts’ perceptions and policy action by the central bank is reducing.
In India, at least since 1990’s GOI and RBI have reconciled to the reality that fiscal and monetary policies are married with no option for a divorce. RBI has never asserted supremacy of monetary policy over the economic policy expectations of GOI. If there were visible frictions in their relationship, they emanated from the poor understanding on the part of certain individuals, of the roles of GOI represented by the finance ministry and the RBI, the institution responsible to implement certain mandated responsibilities.
The Monetary Policy Committee which has now been institutionalized by amending the RBI Act in reality is just a formalization of the role assigned to it by the Preamble of RBI Act, which has been played reasonably well by RBI, all along. 
The clarity in the institutional mind of RBI as regards the objective of monetary policy and price stability comes out in uncertain terms in the then governor Dr C Rangarajan’s   observations on the objectives of monetary policy and price stability in relation to the economy of India at the Second Conference of the Econometric Society’s Regional Chapter for India and South Asia in Delhi on December 28, 1996 (see Box).
Monetary Policy continuity
The policy perceptions of RBI has continuity, despite the relatively short term nature of appointments at top level. This is evident from the observations made by Dr Raghuram Rajan, who was governor during 2013-16, in a speech delivered at the Tata Institute of Fundamental Research (TIFR) on June 20,2016 (almost 20 years after Dr Rangarajan’s speech quoted above). He said:
“The received wisdom in monetary economics today is therefore that a central bank serves the country and the cause of growth best by keeping inflation low and stable around the target it is given by the government. This contrast with the earlier prevailing view in economics that by pumping up demand through dramatic interest rate cuts, the central bank could generate sustained growth, albeit with some inflation. That view proved hopelessly optimistic about the powers of the central bank.
Put differently, when people say, ‘Inflation is low, you can now turn to stimulating growth’, they really do not understand that these are  two sides of the same coin. The RBI always sets the policy rate as low as it can, consistent with meeting its inflation objective. Indeed, the fact that inflation is fairly close to the upper bound of our target zone today suggests we have not been overly hawkish, and were wise to disregard advice in the past to cut more deeply. If a critic believes interest rates are excessively high, he either has to argue the government-set inflation target should be higher than it is today, or that the RBI is excessively pessimistic about the path of future inflation. He cannot have it both ways, want lower inflation as well as lower policy rares.
At the same time, the RBI does not focus on inflation to the exclusion of growth. If inflation rises sharply, for instance, because of a sharp rise in the price of oil,it would not be sensible for a central bank to bring inflation within its target band immediately by raising interest rates so high as to kill all economic activity. Instead, it makes sense to bring inflation back under control over the medium term, that is, the next two years or so, by raising rates steadily to the point where the bank thinks it would be enough to bring inflation back within the target range…..More generally, the extended glide path over which we are bringing inflation in check appropriately balances inflation and the need for reasonable growth.”
The emphasis, obviously is on the policy continuity at RBI with focus on price stability and growth, over decades, despite all constraints and pressures from various stakeholders.
 The confidence with which RBI is moving forward simultaneously on policy front and in prompt initiation of regulatory and supervisory measures is building trust in those who are managing the institutional system in the financial sector. The central bank has, as expected, taken in its stride the pressures from policy makers in Delhi and those who are affected by its more stringent supervisory and regulatory stance to discipline players in the economy who are reluctant to fall in line. The message is, the RBI is willing to act decisively where warranted.
June 6 Policy Announcement
While announcing the Bimonthly Monetary Policy on June 6, 2019, RBI observed:
The MPC notes that growth impulses have weakened significantly as reflected in a further widening of the output gap compared to the April 2019 policy. A sharp slowdown in investment activity along with a continuing moderation in private consumption growth is a matter of concern. The headline inflation trajectory remains below the target mandated to the MPC even after taking into account the expected transmission of the past two policy rate cuts. Hence, there is scope for the MPC to accommodate growth concerns by supporting efforts to boost aggregate demand, and in particular, reinvigorate private investment activity, while remaining consistent with its flexible inflation targeting mandate.’
Governor’s observation in the post-policy announcement interaction with the media that the ‘decision is driven by growth concerns and inflation concerns in that order’ says it all.
Transmission of interest rates
A change in base rate by itself doesn’t mean much for the economy in the Indian context, as the banking system’s dependence on RBI is not significant. So far, the message that a cut in base rate by, say, 25 basis points in base rate is an expression of expectation that banks will reduce lending and deposit rates by quarter percent or near-about has not gone down the line loud and clear. There are reasons for this. Banks are aware of this expectation. But there are market realities. Banks’ term deposit rates have some relationship with  government’s own savings schemes like Provident Fund and National Savings Schemes. Savers expect a reasonably positive return on their savings, net of inflation. So, there are constraints in reducing deposit rates. Despite all these, there exists a case for reducing lending rates, by reducing the need for high margins. If margins have to come down, efficiency in fund management, recovery rate and overall discipline in the financial system should improve. Here, RBI will expect support from policy makers and judiciary.
Signals from Mint Road
RBI-watchers have started assessing the impact of the presence of new governor Shaktikanta Das at RBI. Six months is too short a period for such exercises. But intuitively, I feel the tidings are positive and with Nirmala Sitharaman as Finance Minister, the decade-old uncertainties in the relationship between North Block and Mint Road will become a memory we can push into archives. Why?
The change in RBI’s own monetary policy stance from ‘neutral’ to ‘accommodative’ can be considered as symbolic. The IAS grounding and cordial relationship with his erstwhile colleagues in the Finance Ministry are helping the new RBI governor in solving contentious issues amicably with GOI.
Review of February 12, 2018 circular
By any yardstick, RBI’s February 12,2018 circular on handling loan defaults was a landmark in regulatory guidance from the central bank. When the matter reached Apex Court, while the authority of the RBI was not contested, the circular was set aside on legal/technical grounds. RBI deserves praise for coming out with a revised version of the circular fast, rectifying some of the irritants in the original circular. The modifications in instructions include more time for banks for completing certain processes, bringing down the need for the assent of creditors to 75% for restructuring plan, provided all creditors agree to restructuring in principle and discretion to lenders with regard to design and implementation of resolution plans.
Transfer of RBI’s surplus to GOI
A Panel headed by former governor Bimal Jalan which examined the adequacy of reserve with RBI will be submitting its report shortly. Now, armed with the expert views, RBI will be able to take an informed decision on the issue. In case the Panel fails to come to a consensus on capital and reserves requirement of RBI, accretion of surpluses and their deployment including the modalities of arriving at transferable surplus, one expects the provisions of the RBI Act will be respected and GOI and RBI will amicably sort out the issue.
****************

 Excerpts* from the then RBI Governor Dr. C. Rangarajan’s observations on the objectives of monetary policy and price stability in relation to the economy of India at the Second Conference of the Econometric Society’s Regional Chapter for India and South Asia in Delhi on 28/12/96.
I would like to take this opportunity given to me this morning to raise one issue in monetary policy that still remains contentious despite overwhelming agreement among policy makers in industrially advanced countries. The issue relates to the objective of monetary policy. The question is: What should be the objective or objectives of monetary policy and whether in the Indian context, maintenance of price stability should be the dominant objective of monetary policy?
2 The issue of objective has become important because of the need to provide clear guidance to monetary policy makers. Indeed this aspect has assumed added significance in the context of the increasing stress on autonomy of central banks. While autonomy has to go with accountability, accountability itself requires a clear enunciation of goals.
3 Monetary policy has now moved to the centre stage of economic policy-making the world over. In the 1930s and in the first two decades after the Second World War, monetary policy was relegated to the background. The ascendancy of fiscal policy during this period was due in part to the depression of the 1930s, and the process of reconstruction immediately after the Second World War and the acceptance of the Keynesian dictum that fiscal action was necessary to prevent deficiency in the aggregate demand. However, the 1970s saw the emergence of a combination of high inflation and low growth - ‘stagnation’ as it came to be called - and the standard Keynesian analysis was hard put to explain that phenomenon. Consequently, monetary policy re-emerged as an instrument of economic policy particularly in the fight against inflation. Issues relating to the conduct of monetary policy came to the forefront of policy debates in the 1980s. The relative importance of growth and price stability as the objective of monetary policy as well as the appropriate intermediate target of monetary policy became the focus of attention. Over the years, a consensus has emerged among the industrially advanced countries that the dominant objective of monetary policy should be price stability.
Incorporation of this objective in the Maastrischt Treaty is indeed a reflection of this consensus. Differences however, exist among central banks even in industrially advanced countries as regards the appropriate intermediate target. While some central banks consider monetary aggregates and therefore monetary targeting as operationally meaningful, some others focus exclusively on interest rate even though the inter-relationship between the two targets is well recognized.
4 A similar trend regarding monetary policy is discernible in developing economies as well. Much of the early literature on development economics focused on real factors such as savings, investment and technology as main springs of growth. Very little attention was paid to the financial system as a contributory factor to economic growth. In fact, many writers felt that inflation was endemic in the process of economic growth and it was accordingly treated more as a consequence of structural imbalance than as a monetary phenomenon. However, with the accumulated evidence, it became clear that any process of economic growth in which monetary expansion was disregarded also led to inflationary pressures with a consequent impact on economic growth. Accordingly, importance of price stability and therefore the need to use monetary policy for that purpose also assumed importance in developing economies. Nonetheless, the debate on the extent to which price stability should be deemed to be the over-riding objective of monetary policy in such economies continues.
5 Monetary policy is an arm of economic policy and in that sense, the objectives of monetary policy are no different from the overall objectives of economic policy. The broad objectives of monetary policy in India have been
a) to regulate monetary expansion so as to maintain a reasonable degree of price stability; and
b) to ensure adequate expansion in credit to assist economic growth.
The emphasis between the two objectives has changed from year to year depending upon the conditions prevailing in that and the previous year.
6 The question of a dominant objective arises essentially in view of the multiplicity of objectives and the inherent conflict among such objectives. Jan Tinbergen had argued decades ago that it was necessary to have at least one instrument for each target. In this regard, it must be recognized that certain objectives are better suited or more easily achieved with certain instruments than with others. This ‘assignment rule’ favours monetary policy as the most appropriate instrument to achieve the objective of price stability.
7 The crucial question that arises is whether the pursuit of the objective of price stability by monetary authorities undermines the ability of the economy to attain and sustain higher growth. A great deal of research effort has been spent on the examination of the trade-off between economic growth and price stability.
8 The well known Phillips curve showed that there was an inverse relationship between rate of change in wage rate and unemployment rate suggesting thereby a trade-off between inflation and unemployment. The original article of Prof. Phillips was published in 1958. The Phillips curve relationship has subsequently been challenged both from theoretical and empirical standpoints. The downward slope of the curve arises basically because of the presence of money illusion and expected inflation deviating from actual inflation.
9 At present the controversy is centred around the possible short-run and long-run ‘trade-off’ between inflation and unemployment. This distinction primarily stems from the assumption of ‘error-learning’ process in the determination of inflationary expectations - workers do have an anticipation on the inflation, but because they judge the inflation performance from the past data, the adjustment between the expected and actual inflation is slow. This implies that in the short-run, nominal wage rise will not fully absorb the actual inflation, and as such, it is argued, there is scope for reducing unemployment through inflation. As people adjust their expectations of inflation, the short-run Phillips curve shifts upward and the unemployment rate returns towards its ‘natural’ level. As the expected inflation catches up with actual inflation, the Phillips curve becomes vertical, denying thereby a ‘trade-off’ between
inflation and unemployment in the long run. The Phillips curve thus provides at best a temporary trade-off between inflation and unemployment when the economy is adjusting to shocks to
aggregate demand and as long as expected inflation is lower than actual inflation. The long-run Phillips curve becomes almost vertical at the natural rate of unemployment.
10 Of course, there is a possibility of lengthening the short-run ‘trade-offs’ indefinitely, since inflation surprises in each period can elongate the long-run perpetually. But, in that case the ‘trade-offs’ will become sharper in each successive period. In other words, to maintain the unemployment below the ‘natural’ rate, policy authorities will have to inflate the economy at higher rates in each successive period. This has a major policy implication even if the economy does not operate on the long-run vertical Phillips curve. Under the ‘rational expectations hypothesis’, as there are no deviations between ‘actual’, and ‘expected’ inflation, both in the short-run and long-run, Phillips curves are treated as being vertical with no trade-off between inflation and unemployment.
11 Another policy related question is the shape of the short-run Phillips curve itself. In the real world, wages and prices remain sticky, as employment contracts are fairly long and there is also a cost in changing the individual prices too often, or renegotiating wages each time after a price rise. As argued by Fischer (1994), the nature of stickiness in wages and prices could be different in different economies and this could also be a function of the inflation history of the country concerned. Countries with high inflation rates tend to find themselves on the steeper portion of the short-run Phillips curve than low inflation countries which are more likely to be on the flatter side. Therefore, ‘trade-off’ between price stability and employment or output even when it does exist, is sharper for countries with relatively high inflation rates than those with low inflation rates.
12 The case of price stability as the objective of monetary policy rests on the fact that volatility in prices creates uncertainty in decision making. Rising prices affect savings adversely while making speculative investments more attractive. The most important contribution of the financial system to an economy is its ability to augment savings and allocate resources more efficiently. A regime of rising prices vitiates the atmosphere for promotion of savings and allocation of investment. Apart from all of these, there is also a social dimension. Inflation affects adversely those who have no hedges against inflation and that includes all the poorer sections of the community. Of course, a critical question in this context is at what level of inflation the adverse consequences begin to set in.
13 Inflation affects fiscal balance in several ways. It adversely affects fiscal deficit when elasticity of expenditure to inflation is higher than that of revenue. A more significant impact of inflation arises from its effect on interest rate and the dynamic
sustainability of the fiscal situation. High rates of inflation signal weak resolve to control inflation and imply higher expected inflation in future. This gives rise to upward rigidity in nominal interest and leads to high debt service burden on the budget, thus reducing the maneuverability of fiscal management.
14 It is well recognized that adverse implications of inflation are higher at high rates of inflation, while a moderate inflation rate could be manageable without implying severe costs. International evidence suggests that the costs of uncertainty tend to rise in a non-linear fashion with inflation rate exceeding a threshold. One important caveat in interpreting the threshold of inflation rate beyond which costs exceed benefit is the provision of inflation protection measures available in the economy, which tends to moderate the adverse
implications to some extent. Countries with a moderate inflation rate but inadequate indexation provision may show a higher degree of sensitivity to inflation, than those with low inflation. Most of the industrialized countries in the recent years have moved into an inflation rate ranging between two to three per cent. Among the developing countries, some of the fast growing East-Asian economies have in recent years not only demonstrated low inflation rates ranging between three to five per cent, but the growth rate at these inflation rates has been fairly high at around eight per cent.
15 Empirical evidence on the relationship between the inflation and growth in cross-country frameworks is somewhat inconclusive because such studies include countries with inflation rate of as low as one to two per cent as well as countries with inflation rates going beyond 200 and 300 per cent. While a number of studies have concluded that the negative impact of inflation on growth is high at high rates of inflation, there is no consensus about the threshold inflation rate beyond which the negative impact becomes pronounced. A study by Bruno indicated that growth rates declined steeply as the inflation rate went beyond 25 per cent. Another study also based on cross section of countries reported that the negative effect of inflation was very pronounced and powerful at inflation rates exceeding eight per cent. What the appropriate inflation threshold beyond which costs tend to exceed benefits need to be estimated for each country separately. Nevertheless, people worry about even moderate inflation levels because if not held in check, a little inflation can lead to higher inflation and eventually affect growth.
16 A macro-econometric model of the Indian economy shows that a 10 per cent sustained increase in real public investment in non-agriculture sector, financed by money creation leads to an annual inflation rate of about 2.3 per cent and additional GDP growth of one percent, on an average, during the first two years, while in the span of 10 to 15 years, inflation rate rises to about 17 per cent per annum and additional output growth slows down considerably to average 2.7 per cent during this period. This implies that in the long run a sustained improvement in the growth scenario through monetary financing of the deficit could involve a severe trade-off in terms of inflation - every one per cent additional output growth implies nearly 6 to 6.5 per cent rise in inflation rate in the long run.
17 We, in India, need to have an appropriate fix on the acceptable level of inflation rate. In the 1970s, the average annual inflation rate as measured by the wholesale price index was nine per cent. In the 1980s, it was eight per cent. However, in the period between 1990 and 1995, the average inflation rate has remained around 10 per cent. The objective of the policy should be to keep the inflation rate around six per cent. This itself is much higher than what the industrial countries are aiming at and therefore will have some implications for the exchange rate of the rupee. Monetary growth should be so moderated that while meeting the objective of growth it does not push the inflation rate beyond six per cent.
18 A question that arises in this context is whether monetary policy by itself is able to contain inflationary pressures particularly in developing economies like ours. It is true that developing economies like India are subject to greater supply shocks than developed economies. Fluctuations in agricultural output have an important bearing on the price situation. Nevertheless, continuous increase in prices which is what inflation is about cannot occur unless it is sustained by a continuing increase in money supply. Control of the money supply has thus to play an important role in any scheme aimed at controlling inflation.
19 The controversy over the objective of monetary policy has reached such a pitch that some have described central bankism as a religion with hard money as supreme god and inflation as devil. Let me however say that the commitment to a reasonable degree of price stability is not a dogma. It is good economics.
*Source: BIS Review 8/1997(BIS Website)
**Article published in The Global ANALYST, July 2019.

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