August 24, 2021 3:20:52 am
On August 6, when the six-member Monetary Policy Committee (MPC) met, one member, JAYANTH VARMA, differed with the others and argued for taking a “hard look” at continuing the accommodative monetary policy and said “easy money today could lead to high interest rates tomorrow”. Varma, professor of finance and accounting, IIM-Ahmedabad, spoke to GEORGE MATHEW about inflation, growth and interest rates. Edited excerpts:
You had recently mentioned that the balance of risk and reward is gradually shifting and this merits a hard look at the accommodative stance.
Do you think the loose money policy is adding to inflationary pressures?
The balance of risk and reward is gradually shifting because of changes in how the pandemic is impacting the economy. The second wave was much more tragic than the first in terms of the death toll, but it was milder than the first in terms of economic impact. As a result, Covid-19 is beginning to look more like a neutron bomb that kills people but does only mild damage to the productive capacity of the economy. We are thus confronted with a situation where the pandemic may be with us for many years while the economy continues to pick up steam. It is too risky to keep monetary policy highly accommodative for a long horizon in such a situation. And potential rewards are lower because the economy is no longer in the dire straits that it was last year.
Adding to the risks is the issue of inflationary expectations. If the MPC is wrongly perceived to be inadequately concerned about inflation, then even a transient supply-driven inflationary shock could become persistent because of self-fulfilling expectations. Inflationary pressures are beginning to show signs of greater persistence and it appears that inflationary expectations may be becoming more widely entrenched. After averaging above 6 per cent in 2020-21, inflation is forecast to be well above 5 per cent in 2021-22, and is not expected to drop below 5 per cent even in the first quarter of 2022-23, according to RBI projections.
Do you think there’s a need to change the strategy to bring it to the 4 per cent target at the earliest?
I prefer to frame this in terms of risk. There is a band of uncertainty around the 5 per cent forecast particularly at such long horizons. So, the risk that the actual outcome will go even above 6 per cent cannot be ignored. I am arguing for a glide path that provides greater certainty of keeping inflation within the band.
Do you think the accommodative stance is the real reason behind the stock market boom?
I don’t want to wade into this debate. You had differed with other members of the MPC in the recent meeting. Are you saying that the time for interest rates to go up is fast approaching?
The actual interest rates in the money market are well below 4 per cent; they are in fact close to the reverse repo rate of 3.35 per cent. I would like money market rates to rise closer to 4 per cent. I am, however, keen on keeping market interest rates at around 4 per cent for as long as possible.
You had mentioned in the MPC meet that the pandemic has been devastating for weaker sections and affluent segment has weathered the storm. Do you think the government and regulators will have to change their strategy for equitable and fair upliftment of all sections of society?
My argument is that fiscal policy measures like Direct Benefit Transfers are actually reaching the weaker sections of the society, but monetary policy cannot do so. So, I think that pandemic relief has to shift towards more of targeted fiscal support than generalised monetary easing.
Will a reversal of policy stance impact a faster recovery in growth?
Recovery from the pandemic is progressing reasonably well. But even the pre-pandemic economic situation was one of economic weakness that required monetary accommodation. A negative real interest rate of about 1-1.5 per cent is warranted and the repo rate of 4 per cent is consistent with that. Persistent high inflation means that the monetary accommodation has to be somewhat restrained, and, therefore, a markedly more negative real interest rate is in my view too risky. I am arguing for raising money market rates towards the repo rate of 4 per cent from the current ultra-low level of 3.35 per cent, and then keeping the repo rate at 4 per cent as long as possible.
Can you explain why you differed with other members on the reverse repo rate? You wanted to bring it within the remit of MPC and argued for phased normalisation of the width of the corridor.
No, I did not ask for it to be brought within the MPC remit. I argued instead that by including the line about the reverse repo rate in the MPC statement instead of the Governor’s statement, the MPC is in some sense being asked to take responsibility for it and, therefore, a discussion of this rate is necessary.
You had said easy money today could lead to high interest rates tomorrow. Can you elaborate?
This is thorough the expectations channel. Excessively low rates increase inflationary expectations that lead to higher inflation with a lag, and an inflation targeting MPC is then forced to respond to this with harsher tightening than would have been needed if it had acted earlier. Of course, I did not invent this idea that easy money today could lead to high interest rates tomorrow. Milton Friedman explained the phenomenon very clearly many decades ago.
What’s your assessment on private capex? Why is it not picking up despite low interest rates?
I think capacity utilisation is slowly inching up to the levels where new capacity expansion becomes attractive. Hence, I remain hopeful that capex will start picking up. My statement argues that a stable macroeconomic environment in terms of both interest rates and inflation rates would encourage this investment.
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