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Mandate-Constrained MPC Kept Rates On Hold As India Hurtles Towards Recession

Monetary policy is forced into a standstill even when there is space available, wrote RBI Deputy Governor Michael Patra.

A stop sign is displayed on the barrier of a railway crossing as a train travels past near Chunabhatti railway station in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)
A stop sign is displayed on the barrier of a railway crossing as a train travels past near Chunabhatti railway station in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

India’s six-member Monetary Policy Committee felt the constraints of its inflation target as it met for the last time in its four-year tenure.

Minutes of the MPC meet released on Thursday showed that committee members grappled with striking a balance between inflation, which is running higher than its mandate, and growth, which has collapsed as a result of the Covid-19 outbreak.

The committee kept the benchmark repo rate unchanged at 4% when it announced its decision on Aug. 6. Since March, the MPC has cut rates by 115 basis points to counter the impact of the pandemic. While committee members saw some more space for monetary policy support, the elevated inflation readings pushed them to vote for a status quo with an accommodative stance.

‘Pro-Active’ Supply Side Measures

RBI Governor Shaktikanta Das wrote that generalised inflationary pressures, in a situation where growth is expected to contract sharply, “is a matter of serious concern.”

The slack in the economy suggests there is little risk to inflation from the demand side, said Das. However, supply disruptions and bottlenecks in the post-Covid environment could engender the inflationary impulses visible in the early data, he added.

The containment of these inflation pressures “calls for proactive sector-specific supply-side measure,” Das said.

The governor reiterated that India’s GDP is likely to shrink in the first half of the year, and growth for the full year 2020-21 is estimated to be negative. As the economy continues to be in a fragile state, recovery in growth assumes primacy, he said.

As I have been reiterating since October 2019, monetary policy is geared towards supporting the economic recovery process. Although there is headroom for further monetary policy action, at this juncture it’s important to keep our arsenal dry and use it judiciously.
Shaktikanta Das, Governor, RBI

‘Unshackling Monetary Policy’

RBI Deputy Governor Michael Patra wrote that an “unanticipated concoction” of factors outside the ambit of monetary policy has complicated its conduct.

Patra said that amid the high uncertainty prevailing in the economy and around inflation, two outcomes are possible based on precedents. One, like in 2016-17, food inflation could “fall off a cliff” after an initial rise. Second, like in 2009-10, inflation could surge due to a combination of higher food prices, fiscal stimulus and delayed monetary policy response.

At this stage, with inflation prints above the upper tolerance band, “technical considerations under the monetary policy framework warrant a pre-occupation with dealing with the conditions of failure,” he said.

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. In fact, if inflation persists above the upper tolerance band for one more quarter, 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.  
Michael Patra, RBI Deputy Governor

Patra went on to call for an “unshackling of monetary policy”, asking whether the economy would be able to withstand any such remedial action in this “virus-ravaged, debilitated state.”

“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. The upticks that easing of lockdowns yield are likely to be ephemeral and vulnerable to flattening out due to lack of underlying vigour.”

Skeptical About ‘Stagflationary Conditions’

MPC member Ravindra Dholakia said that the current available data on growth and inflation would suggest that the economy is not caught up in recession with deflation but in a deep stagflation. In such a scenario, expansionary fiscal or monetary policies would first push up inflation before reviving growth.

Dholakia said he is skeptical that such stagflationary conditions exist. “There are high uncertainties and some contradictory evidences about the characterisation of the current and future macroeconomic environment,” he said. “I’m sceptical about the deep stagflationary conditions prevailing in the country.”

Dholakia, however, said the committee cannot ignore its mandate.

Though the present circumstances are truly exceptional, the primary mandate given to MPC for inflation targeting at 4% with the upper tolerance limit of 6% has to be respected. In fact, the confusion and uncertainty created by the imputed CPI-C and implied inflation estimates needs to be cleared by more of regular readings on inflation rates.  
Ravindra Dholakia, MPC Member

Dholakia said that he sees more space for monetary policy action but added “there is no harm in taking a pause at this juncture” since transmission of previous rate cuts remains incomplete.

“In my view, the available space for policy rate should now be used prudently and opportunistically to optimize the impact on the economic recovery,” Dholakia said.

‘Inflation Whipsaw’

Chetan Ghate, among the three members whose tenure ended with the August meet, said that the prospect of an “inflation whipsaw” — a phrase used by Markus Brunnermeir at Princeton — is probably the right way to look at inflation going forward.

“On the upside, a perfect storm of cost push pressures, accommodative monetary policy, and adverse food supply shocks could lead to a pickup in inflation. On the downside, the paradox of thrift, i.e., forced saving pressure induced by a “de-facto” lock-down, could be a potent disinflationary force,” Ghate said.

While noting that the worst in terms of output loss may be behind us, Ghate said that policy needs to be watchful to ensure that a temporary Covid type shock to the Indian economy does not become permanent. 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.”

Ghate, like the rest of the committee, said it would be opportune to “wait and watch to see how the growth inflation numbers pan out over the next few months.”

As a parting message, however, he said that future MPCs should not “go soft” on inflation, at a time when it has remained above 6% for a number of months.

Inflation has now been above the upper band of 6% for a number of months. Notwithstanding large rate cuts to spur growth over the last year and a half, growth has steadily declined despite 250 bps in cuts since February 2019. Future MPCs should not go soft on inflation. Going forward, monetary (and fiscal) policy will be needed to be used wisely with a clear understanding of what and what not they can achieve in terms of controlling inflation, smoothening out the business cycle, and limiting spurious economic volatility.  
Chetan Ghate, MPC Member