The best monetary policy for India?

Author: Ashima Goyal, IGIDR

It is a difficult task to bring down inflation at minimum cost to growth. The problem is even more acute in an economy already facing a negative output gap: where actual output is less than what the economy can produce at full capacity. The growth sacrifice for even a small reduction in inflation on account of monetary tightening in this case can be very large. Yet this is the challenge presently facing India.

How does monetary policy work in such conditions? It is often said that monetary tightening aims at anchoring inflation expectations. But a better understanding is required of exactly how expectations are formed in the larger economy beyond financial markets. Conventionally, decreasing demand and the emergence of a negative output gap should dampen inflation expectations. Yet India’s output gap has been negative for over two years now without significantly denting expectations of high inflation.

In this context, which nominal variable should be targeted by Indian policymakers to reduce inflation and inflation expectations in India? Money itself is no longer particularly effective as close substitutes, such as the gold loans popular in India, make the supply of money somewhat independent of central bank policy. The operative variable, therefore, is the interest rate or the cost of money. But this only enlarges the already negative output gap.

The other nominal variables affecting inflation and the formation of inflation expectations are supply shocks from oil and food prices, the exchange rate that affects these and other costs, the existence of a fiscal deficit, government spending on domestic goods, and various infrastructure bottlenecks that prevent adequate supply responses. These variables can make a persistent contribution to inflation through second-round effects or via multiple supply shocks. India has had all these in the last few years, leading to entrenched inflation expectations.

But thankfully, there are some hopeful trends of late.

To start with, India seems to be settling in to some exchange rate stability around an ‘equilibrium’ real effective exchange rate. The current nominal INR/USD rate of around 62 adeqautely adjusts for India’s inflation differentials with trading partners. This reversal of excessive nominal depreciation, which had contributed to inflation, along with a clear reduction in the current account deficit, may help the economy to cope better with what is likely to be a gentler-than-feared tapering of the US Federal Reserve’s quantitative easing (QE) policy.

Second, despite this being an election year, the government seems committed to meeting its fiscal deficit targets, has only moderately increased minimum support prices for producers, and may cut fourth-quarter spending, as it did last year.

Finally, rural nominal wage growth is down from 20 to 15 per cent, while in real terms wages in August were up only 2 per cent year-on-year. Wages in the last few years were overcorrecting to steep food price increases, which had major second-round effects on inflation.

Working against these positive trends is the fact that the government has no long-term strategy for tackling food inflation. Reducing its excessive focus on food grains and eliminating the distortions of agricultural marketing programmes would encourage crop diversification and meet changing consumer demand. Without action, food inflation will continue to drive wage increases and force monetary tightening, squeezing industry from both sides.

Given the short-run positives outlined above, a neutral policy rate, such as the current repo rate of 7.75 per cent, should be enough to anchor inflation expectations. Further monetary tightening could lead to a destruction of potential output of the kind India experienced in recent periods as investment collapsed. But there is still a 2–3 per cent negative output gap. This could compensate for headline or CPI core inflation that is 1–3 per cent above target. India also had liquidity tightening measures recently, which have pushed the operative interest rate far above the ‘neutral’ repo rate.

The liquidity tightening measures were aimed at stabilising the rupee. But event-based data analysis shows that what actually worked, apart from a delay in the tapering of QE, was the intelligent use of foreign exchange reserves. Taking oil marketing companies’ demand out of the fragile foreign exchange market was especially useful. The interest rate defence and tightening only created unnecessary collateral damage.

There is now financial-disintermediation (a fall in the use of financial products) as firms are finding it cheaper to borrow from banks rather than markets, even though banks are passing on their higher cost of funds. Tight liquidity has forced the State Bank of India (SBI) to stop discounting commercial bills other than those from the SBI group. There is an associated rise in hedging costs for small firms. In the process, large shocks have been delivered to the system.

A more gradual return to normality would be best, especially if money markets are effectively deepened along the way with a richer menu of instruments and trades. Term money markets have not developed in India despite past efforts. Rationing liquidity in different time buckets may help kick-start these markets.

The lessons for future ‘taper preparedness’ should be to focus on bolstering forex reserves when opportunities present themselves, reducing fiscal and current account deficits, and reviving growth. Reserves can then be used to smooth demand and supply mismatches when uncertainty is high. India’s economy must be made robust, not kept fragile by tight liquidity.

Ashima Goyal is Professor of Economics at the Indira Gandhi Institute of Development Research, Mumbai.

A version of this article was first published here, in The Hindu Business Line, on 18 November 2013