Is the Monetary Policy Dead?

 

The recent monetary policy announcement by the RBI governor was not surprising in terms of its actions. It has chosen to retain the key ratios as they are. Further, they have indicated the possibility of a continuing negative growth of the GDP in the remainder part of the financial year. The inflation is relatively higher in CPI terms but low in terms of WPI. Foreign direct investment continues to increase with India currently having the largest quantum of foreign exchange reserves in its history. It would however be pertinent to understand the dynamics of monetary policy at this stage.

 

Monetary policy as noted in earlier posts too, is rooted in stimulating demand and supply through changes in the price of money, the interest rates. Either the policy can point towards interest rate stability which implies continued changes in money supply. Alternatively, if the focus is on stable money supply, interest rates have to keep on changing to achieve the desired money supply target. In the normal context, this works well. In the Indian scenario, the inflation targeting meant that the onus was on RBI to keep the inflation within the suggested parameters. This, they would seek to achieve through changes in interest rate. As one is aware, inflation is a function of money supply which in turn is an autonomous variable under the control of the central bank. Money demand on the other hand is a function of interest rates. Yet, we are living in uncertain times and hence monetary policy as conventionally assumed would not work.

 

It is worth reiterating the pandemic induced by the Chinese virus has disrupted both aggregate demand (AD) and aggregate supply (AS). Because of the lockdown and consequent restrictions on production side, the AS declined. Furthermore, the decline in the availability of labour thanks to the migration back home further disrupted the production. Given the scare of infection, the demand side too has witnessed reduction. A lower AD will further reduce AS thus creating an equilibrium at a lower output and lower price level. It might however happen that a cost push inflation thanks to rise in wages might result in a paradox of higher price levels though lower levels of output. The domestic output declines because of drop in both investment and consumption. The external sector too cannot help much as the pandemic has swept the whole world. Hardly an economy exists wherein the countries have not experienced sharp economic declines something unseen since the Great Depression around a century ago. This virtually means the decline in exports. Since the domestic supply and demand too would have been affected, the imports too would drop. So therefore in the Indian context it apparently seems the exports have dropped less than proportion to drop in imports thus a paradoxical current account surplus something rare in recent times for Indian economy.

Yet, as quite a few commentators mention, the limitations of the monetary policy are visible. In the Western world, the monetary policy was the preferred instrument to set the economy in a direction the country wants because it was less intrusive. It was an indirect attempt to increase or temper the consumption or investment as the case might be. Given the price of money, the consumption and investment patterns would change. At lower interest rates, investment and consumption would pick up while the inverse resulted at higher interest rates. Essentially the monetary policy functioned on the paradigm of induced spending whether on consumption goods or investment goods. However the COVID times have put a brake to the induced investment and consumption.

 

The induced investment or consumption is just one element in the economic growth paradigm. There is another element, the autonomous factor. This autonomous investment or consumption is that component of investment or consumption that is independent of interest rates. Consumption of essentials for examples or investment in charitable projects are often cited as examples of independent of interest rates. Thus these factors come into play. While in the normal course, the factors independent of interest rates are usually small but in these unusual times, the autonomous factor overrides everything else in determining the trajectory of economic growth.

 

The current times need to factor in the marginal propensity to self-protect. This implies a reluctance of people to offer themselves in the labour market. Secondly, given the possibility of infection, people would not venture out unless there is a compulsion to so. Evidence does point out toward low occupancy in flights and trains though the situation seems to be picking up slowly. Furthermore, the rise in demand for many sectors is more of pent-up demand, some buying decisions that were postponed because of the lockdown. The demand patterns are likely to remain slack for some more period of time. Given the induced slowdown, it is also possible, the firms would be more interested in clearing the inventory than any fresh production. However, a possibility of V-Shaped recovery would lead to increasing investment.

 

Moreover, as quite many experts have suggested, the focus must be on transition with sustained solvency of firms and individuals till such time the danger of pandemic passes by either through cure, through vaccine or through social distancing induced break down of chain of transmission. What would be pertinent as discussed earlier too, is the increased role of the government. There are indications in some quarters of fiscal deficit breaching the six percent mark something double the projected three percent. In these times, there needs to be deficit spending even factoring some element of inflation. The fiscal deficit would sort itself out once the recovery process begins. The fiscal deficit is not unique to India but would be something of a universal phenomenon.

 

The current government intervention has to be direct in terms of increased government expenditure on construction and infrastructure whereas the indirect element would be the series of policy incentives and legislative changes that have been introduced. At the stage wherein the Indian economy finds itself now, the monetary policy seems to be losing its relevance. The monetary policy might not carry much significance for some more time. At this stage, the RBI statement would be their projections of the economic trajectories but beyond that hardly anything significant. This might be a controversial and unpopular assertion but this is a fact.