Financial inclusion shaping rate-setting decisions now: RBI's Michael Patra

Financial inclusion lowest in rural and agriculture-dependent areas where food is the main source of income, say deputy governor.

Financial inclusion is increasingly influence monetary policy and a formal system to gauge it helps, said Michael Patra, deputy governor at the Reserve Bank of India (RBI), on Friday.

The RBI launched a national financial inclusion index (FI-Index) in September, using 97 indicators to gauge financial inclusion. According to it, the country has achieved just about half of its goal in financial inclusion.

“Furthermore, a measurable indicator of financial inclusion can be incorporated into monetary policy rules and reaction functions to examine its correlation with output and inflation and their volatility. For the first time, the influence of financial inclusion on the size and timing of policy rate changes can be gauged,” Patra said in his address at a financial inclusion seminar organised by the Indian Institute of Management, Ahmedabad.  

"Monetary policy authorities typically avoid discussions on inequality. They like to be seen in a macro-stabilisation role and prefer leaving distributional issues to fiscal authorities. Yet, increasingly, they realise that financial inclusion – or the equality of access to formal finance – impacts the conduct of monetary policy more fundamentally than they thought,” said Patra, who is in charge of monetary policy.

Financial inclusion helps “in the choice of metric for measuring goal variables, in the choice of trade-off between their variances, and in the efficacy of monetary policy in reaching out to the broader economy."

There is a two-way relationship between monetary policy and financial inclusion, and “it is unambiguous that financial inclusion is able to dampen inflation and output volatility".

This is because with more included in the formal financial fold, the people become interest-sensitive, and the society becomes intolerant to inflation. This helps the monetary policy to achieve its objective in a shorter period than otherwise.  

Inflation targeting monetary policy tries to shield the fringe from the adverse shocks of sharp price rise.  

Financial inclusion evades rural India

According to Patra, financial inclusion is lowest in rural, agriculture-dependent areas where food is the main source of income. When food prices rise, the extra income earned by the financially excluded is not saved but instead, consumption is increased, leading to higher aggregate demand.  

“In this kind of a situation, the efficacy of monetary policy in achieving its stabilisation objective increases by targeting a measure of prices that includes food prices rather than one that excludes them such as core inflation. The lower the level of financial inclusion, therefore, the stronger is the case for price stability being defined in terms of headline inflation rather than any measure of core inflation that strips out food and fuel."

Food accounts for 46 per cent of the consumer price index (CPI), the main gauge of inflation. This is also the highest share in the world. In this also, the rural index has a share of 54.2 per cent allotted to food, as compared with 36.3 per cent in the urban index (which is also sizeable in a cross-country perspective). Therefore, demand is highly influenced by food and farm output, rather than interest rate changes. That is why the monetary policy framework choose CPI as the main gauge of inflation targeting, Patra said.

“The evidence is still forming and strong conclusions from its analysis may be premature, but India’s monetary policy is by design financially inclusive and it will reap the benefits of this strategy in the future in terms of effectiveness and welfare maximisation.”

The monetary policy’s objective is to keep output close to its potential and inflation aligned to its target (presently at a mid-point of 4 per cent, +/-2 per cent).  

“Overarchingly, however, it is inflation volatility that affects all consumers, whether included or excluded. Therefore, minimising inflation volatility should be the predominant objective of monetary policy in its welfare maximising role,” Patra said.  

The central bank has largely achieved its policy mandate, but for the exceptional experience with the pandemic, and “looking ahead, inflation is expected to trend down over the next two years to converge to the target.”

According to the deputy governor, the central bank’s inflation fight has resulted in “stabilising expectations, winning foreign investor confidence and earning credibility for the conduct of monetary policy,” and rising financial inclusion had a “significant contribution to this virtuous outcome.”

As the pandemic subsides, the output volatility would come down, "providing headroom for monetary policy to remain focused on minimising inflation volatility, which brings welfare gains for all,” he said.

Monetary policy transmission can improve through financial inclusion. When people move their savings from cash to interest-bearing bank deposits and other financial assets the interest sensitivity of financial savings in the economy goes up and enables banks to improve their credit, which itself is interest-rate sensitive.  

"All in all, financial inclusion enhances the potency of interest-rate based monetary policy by causing an increasing number of people to become responsive to interest rate cycles. In turn, this prompts appropriate smoothing behaviour,” Patra said, adding it allows the central banks to tinker less with their interest rates.