Time to reassess monetary policy positions

Economic activity has recovered swiftly with the decline in Covid-19 cases. Activity tracked by the Nomura India Business Resumption Index, for instance, recently crossed the pre-pandemic level for the first time. Although the pandemic risk has not completely abated, particularly given the level of vaccination, it is perhaps time to start rolling back the emergency response to the crisis. In its latest review, the Monetary Policy Committee (MPC) left the policy rate unchanged with the assurance to keep the stance accommodative as long as necessary.

Some difference of opinion, however, is beginning to emerge in the rate-setting committee. External member Jayanth Varma, for instance, argued that monetary policy is less effective in providing targeted relief and appears to be stimulating asset price inflation. The inflation rate, based on the consumer price index, has also surprised the MPC on the upside. Even a minor deviation on the upside from the projected rate of 5.7 per cent for the current year could take the average inflation to over 6 per cent for the second consecutive year. As Prof Varma noted, a perception that MPC is exclusively focused on growth can increase the risk of dis-anchoring inflation expectation. The Reserve Bank of India (RBI) is of the view that higher inflation is transitory and driven by supply-side factors. It is correct that demand is still weak, but persistent higher inflation could pose risks. However, India is not the only country that needs to reassess its policy position. The minutes of the latest Federal Reserve meeting, for example, indicated that it is also contemplating tapering asset purchase. But Fed Chairman Jerome Powell has maintained that higher inflation is transient. 

Past and present: To be fair, the view of large central banks is supported by history. Since the disruption caused by the Covid-19 pandemic has often been compared with war, economists at Goldman Sachs in a recent study used data starting from the 1300s to show how inflation and bond yields reacted after the 12 biggest wars and epidemics. The sample included France, Germany, the Netherlands, Italy, Spain, the UK, the US, and Japan. Predictably, wars resulted in higher inflation and bond yields. Inflation, however, remained weak during the pandemics. The median inflation fluctuated close to zero for nine years after the pandemic ended. Another study of European countries by economists at the central bank of the Netherlands arrived at similar results. The trend rate fell significantly below the initial level for about a decade. It took about two decades for trend inflation to revert to the pre-pandemic level. Historically, pandemics have had a significant impact on economic activity and prices. 

However, medium-term outcomes could be very different this time for a variety of reasons. First, the overall global policy response has been truly unprecedented. According to one estimate, central banks have been pumping over $800 million per hour into the system over the last 18 months, and it is likely to continue in the near term. Second, vaccines have been made available in record time and would enable an early return to normalcy. Third, technology facilitated better understanding of the pandemic and has helped minimise risk in the resumption of activity, except in some sectors. Fourth, technology also helped a large part of the workforce to operate remotely, which restricted the decline in economic activity and income. 
 

The next steps: Although the pandemic is unlikely to end immediately, its impact on economic activity would slowly wane. Economic policy will need to adjust accordingly. The pace of adjustment could be significantly different in different economies, which would have its own implications. The Indian central bank, however, would have added complications. Contrary to general expectation, on average, inflation has remained significantly above the target of 4 per cent since the outbreak of the pandemic. Even with weak aggregate demand conditions, sustained higher prices could affect the central bank’s credibility. In a 2020 World Bank paper (“Inflation Targeting in India: An Interim Assessment”), economist Barry Eichengreen and others, for instance, noted: “... even if the shock is transient, there is the danger that allowing inflation to stray above the top of the target range may un-anchor inflation expectations. Agents may see current inflation above target as evidence that the central bank has lost control of the inflation process...if monetary policy lacks credibility, the costs of monetary accommodation of the shock will be greater.” 

It is nobody’s case that the MPC should start increasing policy rates. However, additional policy accommodation pushed by the RBI outside the MPC’s remit should now be reviewed. RBI reduced the reverse repo rate disproportionately in March 2020 to broaden the policy corridor and flooded the system with liquidity which pushed market rates even lower. Interestingly, Prof Varma has argued in favour of normalising the policy corridor, though the MPC cannot change the reverse repo rate. The 2020-21 edition of the Report on Currency and Finance argued that decisions related to a change in the reverse repo and marginal standing facility rate, and their announcement be shifted out of the MPC resolution. 

 On the contrary, though it would require amending the law, the decision to change the entire policy corridor should be brought under the remit of the MPC and the RBI should target to keep the weighted average call rate within the corridor. This would help enhance the credibility of the central bank. Changes in the policy corridor by the RBI can undermine the position of the MPC. As the World Bank paper showed, there is evidence that inflation has become better anchored after the adoption of the inflation-targeting framework and, contrary to popular perception, adjusting for inflation and output gap, policy rates have come down. It is vital for the Indian policy establishment to preserve these hard-won gains.