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MPC Minutes: Downbeat Monetary Policy Committee Did What It Could — Cut Rates

Downbeat Monetary Policy Committee did what it could — cut rates...

Police officers stand guard at the Reserve Bank of India (RBI) building in Mumbai, India. (Photographer: Kanishka Sonthalia/Bloomberg)
Police officers stand guard at the Reserve Bank of India (RBI) building in Mumbai, India. (Photographer: Kanishka Sonthalia/Bloomberg)

India’s six member Monetary Policy Committee warned about the grave implication of the Covid-19 crisis on the Indian economy, as it proceeded to cut its policy repo rate again by 40 basis points to 4% at its second emergency meeting on May 22. Minutes of the meeting were released on Friday.

The minutes mirrored the downbeat mood prevailing in the economy with committee members choosing to replace their cautiously worded commentary with stark warnings of a “meltdown in demand”, “destruction of economic activity”, “huge negative growth” in the first quarter of the current financial year, and the “deleterious” impact the Covid-19 crisis is having on the Indian economy.

While committee members acknowledged that easier monetary policy may not have an immediate positive impact, they felt it necessary to reinforce their commitment to supporting a revival in the economy and ensuring comfortable financial conditions.

Shaktikanta Das, RBI Governor

Das, in his commentary, said growth outlook has deteriorated sharply and there is still uncertainty as to when the Covid curve will flatten. “While the supply side is expected to ease gradually as the lockdown-related restrictions are phased out, it is the demand side, which will continue to weigh heavily on economic activity for some time to come,” Das wrote.

Das highlighted:

  • Economic activity is expected to contract in the first half of 2020-21 before recovering gradually in the second half. Overall, the GDP growth in 2020-21 is estimated to remain in negative territory.
  • The “meltdown in demand” is likely to result in a significant easing of price pressures in core goods and services. Weak demand conditions could result in headline inflation falling below the target rate during third and fourth quarters of 2020-21.
  • The key challenge for monetary policy at this stage is to resuscitate domestic demand to avoid any harmful effect on income and employment in the short run and potential growth over the medium term.
  • In assessing the magnitude of policy space, it is important to take into account the weak growth momentum, the need for prioritising growth in view of the less risky inflation outlook, and the need to assure benign financial conditions ahead of the recovery taking hold so that confidence is sustained.

Das also explained the decision to call a second emergency meeting of the MPC, saying that “a delay in monetary policy action could potentially become a source of risk itself to the deteriorating growth outlook.”

Michael Patra, RBI Deputy Governor

The strongest warning about the impact of the Covid-19 crisis came from Patra, who heads monetary policy at the central bank. “My view is that the damage is so deep and extensive that India’s potential output has been pushed down, and it will take years to repair,” he wrote.

Patra said:

  • In the deliberations of the MPC, my view is that the threats to growth have to be addressed frontally and aggressively, or risk a more dire outlook.
  • The large monetary stimulus and fiscal effort are striving to put a floor under the aggregate demand.
  • Private consumption is tenuously holding on to positive territory, but spending patterns have altered drastically away from the discretionary and to the essential.
  • Bank deposits are growing faster than a year ago, driven by a precautionary savings instinct in these times of heightened uncertainty. It is important to break this recessionary loop, shore up the erosion in confidence, incentivise banks to invest and lend, and people to spend.
  • Incoming data suggests that the food price spike due to supply disruptions has very little persistence and dispersion and can be looked through for policy purposes.
  • In the evolving configuration of growth and inflation, monetary policy can inspire confidence among households and businesses to break the vortex of public preference for deposits over spending and banks’ aversion to lend and invest.
  • These considerations warrant backing up past actions and stance with another decisive reduction in the policy rate while persevering with the accommodative stance.
  • The size of the rate reduction needs to be calibrated to the space opened up by the inflation outlook, after allowing for margins of error in these fluid and uncertain times, while keeping in mind the ramifications of the size of the rate reduction for financial stability.

Janak Raj, RBI Executive Director

Raj said the Indian economy is staring at “a huge negative growth in the current quarter and overall negative growth for the year as a whole.” He added that “both demand and supply sides of the economy have collapsed” but supplies are expected to recover faster than demand.

According to Raj:

  • While private consumption is likely to slowdown from pre-Covid demand, investment demand is likely to be impacted more severely.
  • Given the collapse in demand, excess capacity is likely to be created in many sectors. This, combined with huge uncertainty about future demand, both domestic and external, is likely to hamper new investments in the private sector. In addition, the focus of governments may also be on revenue expenditure rather than capital expenditure.
  • Monetary policy has been eased significantly since February 2019 and the government has also taken several measures, which will help mitigate deleterious impact of Covid-19 on aggregate demand. However, an unprecedented collapse in demand calls for further easing of financing conditions.
  • Given the long transmission lags with which monetary policy operates, it is important to create enabling financing conditions so that economic activity takes off swiftly as soon as normalcy is restored. Should inflation trajectory turn out as expected, some more policy space may open up, going forward.
  • For monetary policy actions to transmit fully to the credit market, it is important that banks remain well capitalised. Only banks with strong balance sheets could be expected to support lending activity as and when credit demand picks up.

Ravindra Dholakia, MPC Member

Dholakia said there is a distinct possibility of a contraction in real GDP in 2020-21. “Even the nominal GDP growth may slip into the negative zone. There are all symptoms of a recession – fall in aggregate demand, negative real growth and high unemployment,” he wrote.

According to Dholakia

  • The government has provided a major fiscal boost through a series of announcements. The role of monetary policy under such circumstances should be to supplement and support the fiscal efforts to bring the economy out of the unprecedented crisis.
  • The fiscal boost given by the central government is likely to result in further slippage of the fiscal deficit-to-GDP ratio of only 150 basis points. Similarly, all states together may raise their fiscal deficit to GDP ratio by about 150 bps. This may not be inflationary and may result in growth recovery.
  • Although the real policy rate in most other comparable countries is zero or negative, in India it is not only positive but relatively very high at around 1.2 to 1.6 percent. I believe that the real policy rate needs to be kept positive but not so high under the present conditions.
  • Once the situation returns to normal and the fiscal and monetary boost measures start generating impacts, the recovering economy in my opinion may require some further boost. It is prudent to preserve some space for the future.

Pami Dua, MPC Member

Dua, who also voted for a 40-basis-point cut along with four other committee members, noted that lower rates may not immediately help the economy but will help raise confidence.

  • Given the severity and depth of the crisis, the macroeconomic impact of the pandemic is turning out to be more severe than initially anticipated.
  • In order to revive growth and mitigate the economic impact of Covid-19, it is important to ease financial conditions further.
  • In the current scenario, with heightened uncertainty and a near-standstill in economic activity, this may not necessarily lead to an immediate increase in borrowing, but should raise consumer confidence and investor sentiment, going forward.

Chetan Ghate, MPC Member

Ghate was the only member who voted for a smaller 25 bps cut in rates. “Rate cuts should be saved for when the economy starts reviving, and not when we are in a lock-down. Rate cuts, assuming that there is transmission and banks lend, works most effectively when the economy is on the upside. The MPC should keep some gunpowder dry,” Ghate argued.

According to him

  • It is not entirely clear to me that Covid-19 constitutes a large disinflationary shock. Inflationary pressures fall with economic slack (the output gap), but rise with expected future inflation and factors related to production costs.
  • In a demand deficient economy, a large rate cut is akin to pushing on a string. For rate cuts to work, banks have to lend.
  • Rate cuts should be seen as part other measures that have already been taken with respect to liquidity policy, social insurance policy, and fiscal policy in dealing with the crisis.
  • The reverse repo rate has been cut thrice in succession to 3.35%. The idea behind the asymmetric cuts is to use the liquidity adjustment facility corridor as an instrument of monetary policy. For all practical purposes the reverse repo rate is now the effective policy rate.
  • I worry that the current quantum of liquidity will be difficult to unwind when things return back to normal. RBI’s liquidity policy has helped stabilise financial markets, but lender of last resort policies, as is widely recognised, are not useful outside a crisis, and thus should not be viewed as part of normal monetary policy.