The Monetary Policy Committee (MPC) retained the key rates in the August round of the review and continued with the so-called accommodative stance. An accommodative stance is interpreted as a policy stance which is largely tilted towards a rate cut or a status quo.
A rate hike is ruled out during this phase. The MPC has consistently maintained, since the start of the COVID-19 pandemic, that growth revival is of utmost priority and inflation spike is transitory. Hence, a majority of members have voted for the continuation of the accommodative stance.
Ever since the MPC came into existence in 2016, the interest rate-setting process has ceased to be a one-man show. Earlier, the Reserve Bank of India (RBI) Governor had the last word on the policy decision. This changed significantly with the MPC formation including external experts.
In some sense, the RBI became only a party of the rate-setting panel of six members. The discussions during the policy meets became broader in nature. There has been some eye-opening questions and some major dissent notes within the MPC over time about the very fundamental nature of the policy stance and forward guidance, etc.
In the August monetary policy review, too, there are important questions being raised by one of the members, Jayanth Varma, which is made public through the policy minutes released on August 20 that need a closer look.
Here are the major points raised by Varma, explained in a simpler language:
One, COVID is here to stay, despite the high level of vaccinations, at least for the next 3-5 years as the experience in other countries indicate. And the monetary policy's ability to address this pandemic is limited. “The ability of the monetary policy to mitigate a human tragedy of this nature is very limited as compared to its ability to contain an economic crisis,” Varma said. He asks: how long can the monetary policy remain accommodative?
Two, the pandemic has impacted the economically weaker sections in a bigger way, compared to the affluent segments who have weathered it reasonably well. Here again, the ability of the monetary policy to address this impact on the worst-affected segments is much less, compared with the fiscal policy.
Instead, a prolonged accommodative stance could stimulate asset price inflation, Varma says. In other words, the MPC member asks if it is worth continuing the easy money stance for a longer period when there is no clarity of the nature of this crisis and the monetary policy ability is limited to work against COVID? What about the resultant high inflation?
Third, the actual inflation target of the MPC is 4 percent. After averaging above 6 percent in 2020-21, inflation is forecast to be well above 5 percent in 2021-22, and it is not expected to drop below 5 percent even in the first quarter of 2022-23, according to RBI projections. Treating 5 percent as the target would significantly increase the risk of inflation-targeting failures. The question Varma asks here is what should be the actual target of the inflation, compared to the original mandate, considering the risks of high prices on economically weaker sections.
Is MPC concerned about inflation?
Varma points out that the primary aim of the MPC should be to maintain macro-economic stability. By creating the erroneous perception that the MPC is no longer concerned about inflation and it is focused exclusively on growth, the MPC may be inadvertently aggravating the risk that inflationary expectations will be disanchored, he asks.
Varma argues that easy money today could lead to high interest rates tomorrow. On the other hand, by demonstrating its commitment to the inflation target with tangible action, the MPC will be able to anchor expectations, reduce risk premia, and sustain lower long-term interest rates for longer, thereby aiding the economic recovery. Citing this, Varma voted against the accommodative stance.
What are the key takeaways from these points from Varma's notes? The ability of the monetary policy to counter the COVID impact on economically weaker sections is limited, compared with a stronger fiscal response. Also, given that COVID may continue to stay for a longer-than-expected timeframe, there is no clear logic in staying in the easy money stance. Not only may such a stance fail to have the desired impact, the lack of attention to the inflation problem could be risky in the longer term.
Already, there are questions on the MPC’s consistent accommodative stance while simultaneously upping the retail inflation target (5.7 percent now in FY22 Vs 5.1 percent earlier). High prices are hurting the poorer sections most severely. Hence, the RBI can no longer ignore the inflation problem. In this backdrop, Varma has raised some pertinent questions which need to be deliberated well.(Banking Central is a weekly column that keeps a close watch and connects the dots about the sector's most important events for readers.)