Alice Rivlin, an American economist who served as the Vice-Chair of the Federal Reserve (the US central bank), is credited with saying that “The job of the Central Bank is to worry”.
Chances are that if you asked the members of India’s first-ever Monetary Policy Committee (MPC), which ended its term on August 6, they might wholeheartedly agree with Rivlin’s observation.
Just look at the four-year-long tenure of the first MPC — it is more packed with nerve-racking twists and turns than your favourite thriller.
If you don’t recall, let me recap.
Urjit Patel took charge of India’s central bank, the Reserve Bank of India, in September 2016. Patel’s predecessor was the Chicago Booth School economist Raghuram Rajan who ended his initial three-year tenure on a rather acrimonious note.
It was no secret that Rajan’s repeated comments, especially on matters unrelated to monetary policy, were seen as direct criticism by the political masters. There was also the growing frustration in the government, especially in the Finance Ministry that was led by Arun Jaitley at that time, about the RBI not bringing down the interest rates in the economy. The government’s view was that higher-than-merited interest rates were holding back India’s economic growth.
In many ways, the inception of the MPC itself was to make the decision making of the RBI more broad-based. Thus, instead of the RBI, led by the Governor, single-handedly deciding on the benchmark repo-rate (the rate at which the RBI lends money to the banks), it was decided that an MPC will be constituted which will have three members of the RBI and three members nominated by the government.
The first monetary policy review meeting of the MPC took place in October 2016 and immediately, under the leadership of a new Governor (Patel), the MPC delivered a cut in the repo rate by a unanimous decision.
Many observers thought this signalled a phase where the government and the RBI would be more in sync and consequently a quiet phase would follow.
But the MPC and the RBI had no such luck. Just a month after MPC’s first meeting, Prime Minister Narendra Modi, on November 8, 2016, announced the demonetisation of 86% of all currency in a bid to curb black money in the economy.
That one decision set off a chain of events that saw India losing its growth momentum (See Chart Below) progressively in the coming years.
From the monetary policy perspective, demonetisation created such uncertainty that the MPC avoided cutting interest rates for the next 10 months. What further exacerbated their worries was the roll-out of the Seventh Pay Commission award (which increased fiscal constraints and pushed up inflation) and the inept implementation of the Goods and Services Tax (GST) regime. But thanks to the uncertainty, the MPC could not cut rates even though the economy started losing momentum.
By August 2017, the MPC felt there was an “urgent need to reinvigorate private investment” in the economy, and consequently cut the repo rate.
But this cut was the last one for a long while. Even though in the months since, the economy was buffeted by the growing challenges of GST’s implementation.
In the October 2017 policy, the MPC stated: “The implementation of the GST so far also appears to have had an adverse impact, rendering prospects for the manufacturing sector uncertain in the short term. This may further delay the revival of investment activity, which is already hampered by stressed balance sheets of banks and corporates”.
Again in April 2018, MPC stated: “(GST) implementation had an adverse, even if transient, effect on urban consumption through loss of output and employment in the labour-intensive unorganised sector”.
As can be seen from the chart above, India’s economic growth was fast losing steam during 2017 and 2018 but the MPC found itself unable to cut interest rates because there were growing fiscal pressures in the form of a flurry of farm loan waivers (PM Modi’s electoral promise in the run-up to the Assembly elections in Uttar Pradesh in early 2017 provided a huge fillip to this fading trend) as well as hardening crude oil prices. In fact, in June 2018, the MPC had to raise the repo rate as the Indian basket of crude oil rose by 12 per cent within a couple of months.
Two other issues were at play, albeit behind the scenes, that proved significant for the MPC.
One was the now-famous February 2018 circular on the Insolvency and Bankruptcy Code (IBC) by the RBI that became a massive flashpoint between Patel and the government. The other was the issue of RBI reserves and the government’s demand for a much bigger dividend from the RBI — essentially to bridge the ever-expanding fiscal deficit.
Eventually, these two issues led to the unceremonious exit of Governor Patel, who decided to move on before the end of his term.
Patel’s position was filled by the incumbent — Shaktikanta Das — who had earlier served as the Revenue Secretary and the Economic Affairs Secretary, and for those reasons was seen as someone who would finally be able to bring the MPC and RBI’s decision making in sync with the government’s.
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Not surprisingly, under Governor Das, the MPC has repeatedly cut the repo rate. In fact, between February 2019 and May 2020, the MPC has cut the repo rate by 250 basis points (or 2.5 percentage points). But again, as the plummeting growth rate in the chart above shows, this has possibly been the most worrying period for the MPC.
The first-ever MPC appears to have reached a rather humbling end.
For a body that was supposed to solely target retail inflation and keep it at 4% (+/— 2%), the MPC saw retail inflation staying above the 6% mark on all months since December last year (barring March 2020 when it was lower by a whisker).
What is worse, the MPC has no clear understanding of how inflation will pan out. It is not clear whether Covid-19 disruption will be inflationary, disinflationary or, even deflationary.
On the growth front, the picture is even worse. India is staring at a historic contraction of GDP.
Almost all other factors one can consider are also in very bad shape — and not just because of Covid alone.
For instance, monetary transmission continues to struggle. As I mentioned in the last ExplainedSpeaking, the gap between the repo rate and the lending rate on the street is at a historic high.
Bank NPAs have been rising and are likely to rise further. There is growing concern about the trust in the banking system as well.
But perhaps the worst bit about the first MPC’s end is that it has left many wondering about the very efficacy of monetary policy.
If repeated repo rate cuts by the MPC cannot spur economic activity then what is the point of such cuts? Indeed, observers are justified in asking if monetary policy can be of much use when a country’s fiscal policy is massively over-extended.
Those are sobering questions as we look forward to new MPC members. Let’s hope future MPCs live in less interesting times.
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