Monetary Policy Dilemmas: Some RBI Perspectives (Dr. D. subbarao, Governor, RBI)
Monetary policy making is both an art and science. Textbooks typically simplify monetary policy analysis by classifying the various shocks into demand and supply shocks. Under such textbook abstractions, monetary policy actions are unambiguous. If inflation is high, raise interest rates. If inflation is below target, reduce interest rates. But real world problems are too complex to fit template solution of text books. In particular, it is difficult to segregate the shocks neatly into the two boxes of demand shocks and supply shocks and this complicates monetary management.
This blog addresses some of the complexities and dilemmas in the management of monetary policy. In particular, I will focus on two topical issues. First, how should monetary policy deal with shocks which are a combination of both demand and supply factors? And, second, is there any inconsistency between the central bank injecting liquidity while pursuing a tight monetary policy?
What is the appropriate monetary policy response to complex growth-inflation dynamics?
India recovered from the crisis sooner than even other emerging economies, but inflation too caught up with us sooner than elsewhere. Inflation, as measured by the wholesale price index (WPI), which actually went into negative territory for a brief period in mid-2009, started rising in late 2009, and it has remained around 9- 10 per cent since January 2010 reflecting both supply and demand pressures. Supply pressures stemmed from elevated domestic food prices and rising global prices of oil and other commodities. The source of demand pressures was an economy with low per capita income which recovered sharply from the crisis. The supply pressures and demand pressures collided triggering a wider inflationary process.
In response to the inflationary pressures, the Reserve Bank began to reverse its accommodative monetary policy as early as October 2009. We have been criticized for our anti-inflationary stance, ironically from two different directions.
From one side, we have been criticized for being hawkish on inflation. The argument has been that our inflation is driven largely by supply shocks, particularly, since mid-2010, by high oil and other commodity prices, and that monetary policy should not respond to such inflation. We will only end up hurting growth. The criticism from the other side has been that the Reserve Bank has been soft on inflation, the baby step approach we followed - of increasing policy interest rates by 25 basis points (bps) each time - was not deterrent enough, and that the persistence of inflation is a result of our delayed response. Both these critiques cannot obviously be right at the same time. Let me offer a response to them and in the process explain the rationale for our anti-inflationary stance.
Monetary Policy Too Hawkish
My response to the doves is as follows. Admittedly, monetary policy is best suited to contain inflationary pressures stemming from the aggregate demand side. In that case, the policy prescription is clear. If inflation is high, tighten monetary policy; and if inflation is low, loosen monetary policy. Monetary policy options in the face of supply shocks are less straight forward. Whether monetary policy is effective in dealing with supply shocks is therefore a matter of both academic debate and policy contention. The conventional wisdom is that if inflation expectations are well anchored, monetary policy need not react to supply shocks. This premise is based on two assumptions; first that the supply shocks are purely temporary, and second that supply shocks are the only ones driving inflation. These assumptions do not always hold. In the real world, oftentimes supply shocks lead to a permanent trend upward shift in prices. Also, sometimes, demand pressures combine with supply shocks to stoke inflationary pressures.
A good illustration of the first assumption - mean reverting supply shocks - not holding comes from the world prices of oil which have trended up on a long period basis. International crude oil prices recorded an annual average increase of around 17 per cent during the 2000s as against only a modest increase of 2 per cent during the 1990s and a decline of 3 per cent during the 1980s. This obviously is the outcome of structural changes in supply and demand for oil. Monetary policy has to recognize these underlying trends and respond to them. If it looks upon these trends as pure transient supply shocks and ignores them, it runs the risk of destabilizing inflation expectations.
And now about the second assumption - of supply shocks not usually acting alone to stoke inflation. The shifting drivers of inflation in India over the past year and a half offer a good illustration. The increase in global commodity prices coincided with rapidly rising demand at home. GDP grew at 8.5 per cent last year (2010/11), faster than the trend growth rate which is now estimated to be of the order of 8 per cent. In an environment of rapid growth and high capacity utilization, corporates regained pricing power and were able to pass through the increase in input prices to higher output prices thus fuelling generalized inflationary pressures.
Similar dynamics were at play on the food front. Rising incomes, especially toward protein-based foods, have resulted in a shift in dietary habits away from cereals and toward protein-based foods. This is a structural change and monetary policy will be misled if it treats this as a one-off supply shock. Given the high share of food in the various consumer price indices (46%-70%), persistent supply pressures on the food front can fuel inflation expectations; and in the face of growing demand pressures, rising inflation expectations can trigger a wage-price spiral. Recent reports that real wages of rural labour have gone up markedly suggest that such a wage-price spiral may already be under way.
To summarize, the inflation that we have experienced over the last two years - 2010 and 2011 - is a result of a combination of supply shocks that had a trend impact on prices as well as demand pressures. Given the nature of the inflation drivers and their combined impact, clearly there is a significant role for monetary policy in combating inflation. Our monetary policy stance is guided by this understanding, and is aimed at restraining demand and anchoring inflation expectations. The argument of our critics that monetary policy has no role because inflation is a result of imported commodity prices would have been valid if the increase in commodity prices was a pure and transient supply shock or if there were no demand pressures. That clearly was not the case in India.
Monetary Tightening Hurts Growth
Another argument made in this line of criticism is that monetary policy tightening is hurting growth. I believe a much more nuanced evaluation of our policy stance is necessary. Evidence from empirical research suggests that the relationship between growth and inflation is non-linear. At low inflation and stable inflation expectations, there is a trade-off between growth and inflation. But above a certain threshold level of inflation, this relationship reverses, the trade-off disappears, and high inflation actually starts taking a toll on growth. Estimates by the Reserve Bank using different methodologies put the threshold level of inflation in the range of 4% - 6%. With WPI inflation ruling above 9 per cent, we are way past the threshold. At this high level, inflation is unambiguously inimical to growth; it saps investor confidence and erodes medium term growth prospects. The Reserve Bank’s monetary tightening is accordingly geared towards safeguarding medium term growth even if it means some sacrifice in near term growth.
Monetary Policy Behind the Curve
Now let me turn to the criticism from the opposite side - that the Reserve Bank was slow in closing the monetary spigots, that our ‘baby step’ approach was inadequate to tame the inflationary pressures, and that we had to tighten aggressively lately to make up for lost time.
This criticism fails to appreciate the context - the nature of domestic inflation and global uncertainty - in which we were operating. The calibration of our monetary tightening was guided by the changing drivers of inflation over the course of fiscal year 2010/11. Early on in the year, inflation pressures had their origin in food prices, and accordingly our monetary policy response was aimed at containing the spillover risk to non-food inflation. Note that policy rates had gone down to historically low levels during the crisis, and an abrupt adjustment would have disrupted the market. Our judgement, therefore, was that tightening should be done gradually, in small steps, so as to allow time for the banks and the private sector to adjust to a higher interest rate environment.
The inflation scenario changed beginning August 2010 when global commodity prices surged higher than anticipated. Global oil prices came under further pressure starting January 2011 because of political developments in the Middle East and North-Africa. Also, as I had indicated earlier, because of the narrowing of the output gap, producers were able to pass on higher input prices to higher output prices leading to inflationary pressures getting generalized as evidenced by the increase in non-food manufactured product inflation from 5.3 per cent per cent in August 2010 to 8.5 per cent in March 2011. We responded to these changes in underlying drivers of inflation by tightening more aggressively in May 2011 and again in July 2011.
The second factor relevant in the ‘behind the curve’ debate is that we also had to contend with an uncertain global recovery. Even as there was some talk of spring shoots in April 2010, the optimism did not last; soon thereafter, the Greek sovereign debt crisis and unemployment concerns in the US revived concerns about the pace and shape of global recovery. These uncertainties increased both in nature and size as time passed with the euro area sovereign debt problem not only spreading but proving to be intractable, the US recovery stalling and the Japanese economy assaulted by an unprecedented natural disaster. Our ‘baby step’ approach during 2010 was accordingly a delicate balancing act between supporting recovery at home amidst growing global uncertainty and containing inflation pressures.
If the above factors are reckoned with, the ‘behind-the-curve’ argument loses potency. Between March 2010 and October 2011, we raised the policy interest rate (the repo rate) by 375 bp. The effective tightening was even more, 525 bp, as the operational policy rate shifted from reverse repo rate (absorption mode) to repo rate (infusion mode).
As the above discussion shows, every monetary policy action involves complex judgement. The supply shocks we confront in the real world are different from pure text book versions; oftentimes they coincide with rising demand pressures. We had to balance growth-inflation concerns. On top of that, monetary policy actions need to be forward looking even in the face of external uncertainty. This in essence was the dilemma of monetary policy decisions.
How do you justify liquidity injection in the midst of a tightening cycle?
The conventional tools of monetary policy are controls over the volume of money (liquidity) and the price of money (policy interest rate). Typically an expansionary stance would involve easing both the rate and volume, and conversely, a contractionary stance would involve tightening both of them. Occasionally, there arise situations when the price and volume instruments are deployed in opposite directions - for example, injecting liquidity amidst a rate tightening cycle - that call for both cautious judgement and extra effort at communication.
In understanding the motive force for liquidity adjustment by a central bank, it must be noted that a growing economy requires the central bank to inject primary liquidity to meet the requirement for currency and credit. Even if the central bank is in a tightening mode, it needs to provide primary liquidity, albeit the volume of liquidity injection in such a scenario would surely be less than the injection if the monetary policy were in a neutral or easing mode. The injection of central bank liquidity can come about only through an expansion of the reserve (base) money. In the first instance, liquidity injection happens through the overnight borrowing by banks under the Liquidity Adjustment Facility (LAF). If the liquidity shortage is of a durable nature, the central bank needs to meet that need through outright open market operations (OMOs) by buying government securities.
As we progressed with monetary tightening through 2010, the LAF window shifted from a surplus (absorption) mode to a deficit (injection) mode. This was consistent with our anti-inflationary stance since a deficit liquidity situation would improve monetary transmission. We had also indicated clearly that it would be the endeavour of the Reserve Bank to maintain the absorption or injection through the LAF window at about ± 1 per cent of the net demand and time liabilities (NDTL) of banks. However, towards the second half of 2010, systemic liquidity tightened further pushing the injection through the LAF window beyond 1 per cent of NDTL. This was due to a combination of structural and one-off factors. Recognizing that the deficit in systemic liquidity was of a durable nature, the Reserve Bank conducted outright OMOs to inject liquidity of a durable nature during November 2010-January 2011. Again, as liquidity conditions tightened beginning early November 2011, partly reflecting intervention operations in the foreign exchange market, we conducted OMOs during November-December 2011.
The liquidity injection through OMOs during late 2010 and early 2011 happened at a time when we were tightening policy rates to combat inflation. Similarly, the more recent injection of liquidity during November-December 2011 occurred when the monetary policy stance remained tight. These were seemingly contrarian actions, and many observers may have seen them as being conflicting and incoherent. We realized that there was a communication challenge here - to explain to the market that we remained committed to bringing inflation down, that our action in injecting liquidity was not inconsistent with our anti-inflation stance, that we continued to hold that liquidity should be in a deficit mode in a monetary tightening cycle, but that we were injecting liquidity only to ease the ‘excessive deficit’ in order to ensure that flow of credit for productive purposes was not choked.
Informed market participants did, of course, understand the rationale for our actions. But we recognized the importance of communicating the rationale to the public at large. If people got confused policy signals and believed thereby that the central bank’s commitment to inflation control was not credible, inflation expectations would get unhinged and that would erode the effectiveness of our anti-inflation strategy. We, therefore, went the extra mile to communicate the rationale at a non-technical level.
While we have injected durable liquidity through outright OMOs so far, we have other instruments to do the same. These include the statutory liquidity ratio (SLR) and the cash reserve ratio (CRR). We have preferred OMOs to the alternatives since OMOs do not require a change in the monetary policy stance. On the other hand, the CRR and the SLR straddle the divide between liquidity and monetary management. Indeed, in advanced economies, which don’t rely on instruments such as the CRR and the SLR, repo operations/OMOs remain the only instrument of liquidity injection.
To summarise, liquidity injection by the central bank can take place and is indeed necessary even as monetary policy is in a tightening mode. However, there are communication challenges for the central bank in articulating the need for liquidity injection in a tightening phase.