Don’t hit pause in the battle to contain inflation

Hindustan Times April 8, 2023

On April 6, the Reserve Bank of India (RBI) announced its first monetary policy decision of the financial year 2023-24. Going against widespread market expectations, it decided to hold the repo rate at 6.5%, pausing the rate hike cycle that began in May 2022. Unfortunately, the Monetary Policy Committee (MPC) statement does not fully explain why. All we can, therefore, do is speculate about the possible reasons behind this pause and discuss what MPC may need to do going forward.

Let's start by understanding what has changed since the last MPC meeting of February 8. There have been three main developments.

First, inflation pressures have arguably increased. Back in February, when MPC raised the repo (or policy) rate by 25 basis points, the latest data (for December 2022) showed that headline inflation had moderated to 5.7%, whereas going into the latest meeting headline, consumer price index (CPI) inflation had gone up to 6.4% in February 2023. In the run-up to both meetings, core inflation (non-food, non-fuel) remained elevated above 6%, the upper-limit of RBI’s tolerance band.

Second, the global economic environment has become significantly more uncertain compared to February, because of the turmoil in the financial markets in the US and European Union. With the collapse of a few mid-sized banks in the US and the forced take-over of the systemically important Credit Suisse by UBS, financial stability concerns resurfaced, which in turn, complicated the tasks of central bankers.

Third, the rupee-to-dollar exchange rate stabilised in recent weeks, after depreciating chronically in 2022, largely because markets now expect the US Federal Reserve to be less aggressive. The Fed has been tightening monetary policy since the start of 2022, increasing its policy rate from essentially zero to 5%, to rein in inflation which shot up to 9%, the highest in four decades. Arguably, this aggressive tightening triggered the financial instability in the US. The ensuing chaos prompted analysts to expect that the Fed will now slow down the pace of rate hikes in order to balance financial stability concerns with inflation control.

Which of these factors can help explain MPC's latest pause?

Clearly, it was not the first factor, given that inflation is still far from under control. RBI is legally mandated to bring headline CPI inflation down to 4%. Its inflation forecast for 2023-24 is 5.2%, implying that the central bank expects that inflation will remain well above target for the second consecutive year. What is more worrisome is that underlying (core) inflation is likely to be even higher, persistently hovering around 6% for several years now. The MPC statement recognises these problems, stressing the “importance of low and stable prices” and “not letting the guard down on price stability”, while pointing out that work needs to be done to “[anchor] inflation expectations” and “rein in generalisation of price pressures”. Yet, despite such a hawkish assessment, it did not vote in favour of a rate hike.

Why not? One possibility could be that the previous repo rate increases have not been fully passed on by banks to their lending and borrowing rates. So the central bank might have decided that the priority should now shift to ensuring that monetary transmission improves, either by tightening bank liquidity or exhorting banks to raise their rates. But there was no sign of any such initiative in the MPC statement.

So maybe the second factor, global uncertainty, played a key role? Perhaps RBI was worried that problems abroad could weigh on India’s growth? Apparently not. The central bank actually increased its 2023-24 GDP growth forecast, albeit marginally, to 6.5%, indicating that growth worries were likely not the major factor driving its decision.

Perhaps, then, exchange rate factors played the key role. It is certainly striking that RBI’s actions over the past year seem to have been mirroring those of the Fed. When the Fed was aggressively raising rates during 2022, RBI kept increasing its repo rate. And when the Fed decided in 2023 to slow down the pace of rate hikes, RBI responded by pausing. Hence, it is possible that there is some link between US and Indian monetary policy, perhaps motivated by a desire to protect the exchange rate by ensuring that rupee interest rates remain significantly higher than those in the US.

If indeed the pause was driven more by exchange rate factors than by domestic inflation – though RBI governor Shaktikanta Das said that monetary policy was driven by domestic factors, not international – then it needs some reflection. External considerations should not distract RBI from its primary objective of restoring price stability in the domestic economy. Traditionally, ensuring that the exchange rate remained stable against the US dollar could aid in this task, as US inflation used to be low. But times have changed. As long as inflation in developed economies remains elevated, India runs the risk of importing this high inflation.

Consequently, achieving the inflation target will require RBI to focus on exerting downward pressure on domestic inflation, especially now that high core inflation has become entrenched in the system. In particular, MPC needs to ensure that the real interest rate (the difference between the repo rate and core inflation) is firmly in positive territory if there is to be any chance of breaking the persistence of core inflation. Currently, the real rate is barely there.

Persistently high inflation hurts the poor the most. Volatile inflation can be inimical to growth, a troubling possibility given that India’s medium-term growth prospects look uncertain. Therefore, inflation control remains crucial to India’s future. Unfortunately the monetary policy decision did not throw much light on RBI’s plan to bring inflation down.

Should monetary policy be used to target financial stability?

Mint, April 2, 2023 (with Harsh Vardhan)

The recent financial market turmoil in the US triggered by the collapse of the Silicon Valley Bank has raised questions about the impact of the US Fed’s monetary policy on the stability of the banking system. More generally it has brought back to fore a fundamental question that central banks all over the world have been grappling with for a while now – should financial stability be given priority over inflation in the conduct of monetary policy? There is no easy answer to this as both problems are serious.

This issue is of crucial importance for India as well. It has been less than a decade since the Reserve Bank of India adopted inflation targeting as its monetary policy framework and under IT, the primary goal of monetary policy is achieving price stability. Expecting monetary policy to also keep an eye on financial stability, will distract attention from the central bank’s legally mandated objective, and may lead to destabilising outcomes for the economy in general.

There are some practical as well as conceptual problems in making financial stability an objective of monetary policy.

First of all, it is difficult to define financial stability. We can only see financial sector instability when it manifests for example through the failure of a systemically important bank, or the bursting of an asset price bubble, but before such an event occurs, we cannot precisely describe what is financial sector stability. Moreover, there are various institutions in the financial system involving a large number of participants that interact with each other thereby creating a complex, interconnected network. Within this system, sources of financial instability can be varied. We have seen financial instability occurring due to failures of banks, insurance companies, pension funds or mutual funds, and we have seen crises in the stock market and bond market. Ex-ante, it is often difficult to identify the specific part of this vast, complex network where a risk is building up.

Also, once instability occurs in any part of this network, given the interconnectedness, it can spread through the entire system leading to what is commonly known as contagion. It is difficult to predict whether an event of financial instability will indeed trigger a contagion, how rapidly the contagion will spread through the system or what impact it will have on different parts of the network.

Secondly, given that financial stability is difficult to define, it is also hard to measure. Often financial sector regulators use "stress tests" to assess the resilience of the system under various scenarios. Problem is that they only test for risks that they are worried about. There are many other risks beyond the obvious ones and typically those are the ones that get financial institutions into trouble, all the more making financial stability difficult to measure.

Monetary policy works best when it has clearly defined objectives and quantitative targets that guide its formulation. Given the challenges of defining and measuring, it is difficult for monetary policy to target financial stability as compared to price stability which can be both defined as well as measured. In India, for example, the IT framework clearly lays out the goal of the RBI’s monetary policy as achieving a 4% CPI (consumer price index) target. Such a clear, quantitative target is inconceivable when it comes to financial stability.

Finally, and most importantly, policymaking must be guided by the Tinbergen principle which conceives of economic policy as the relation between instruments and goals. It stipulates that the number of achievable goals is limited by the number of available policy instruments. Under the inflation targeting framework, the repo rate in India (or the Fed funds rate in the US) must be used to target inflation. It is therefore best to find another tool to address financial stability so that the Tinbergen principle can be applied.

So if monetary policy is not the answer, then what can be done to address financial instability?

Some have argued that central banks can inject liquidity to safeguard financial instability. There are three problems with this. First, injecting liquidity only makes sense when the underlying problem is illiquidity, say an irrational run against a bank with safe but illiquid assets (such as a loan to a profitable factory). But this is hardly ever the case. Usually, as in the case of SVB, runs occur because banks are insolvent i.e. the value of their assets has fallen below the value of their liabilities. In such a situation, the only solution is to inject capital. Injecting liquidity can in fact make matters worse because it enables more people to flee the ailing bank(s), thereby increasing -- not reducing – panic.

Secondly, liquidity can be a temporary solution in situations involving a credit freeze and, it may help restore confidence in the system. But it is like calling the fire brigade in the event of a fire; it is needed to douse the fire but does not help prevent future fires.

Third, addressing instability using liquidity may also mean keeping the system flooded with excess liquidity for a long time which in turn may endanger price stability.

Broad based financial stability can be achieved only by improving governance standards, and establishing strong supervisory oversight over the concerned institutions to help avoid the build-up of risks. The SVB collapse, like the Global Financial Crisis of 2008, reflected a colossal failure of governance and supervision.

In summary, in the short run, the solution to financial instability is capital; in the long run, it is better governance and supervision. Monetary policy would then be free to pursue its "natural target": price stability.

In the case of India on the other hand, price stability is a pressing concern. CPI inflation has been higher than the RBI's target level of 4% for a while now and in particular, core inflation has been remarkably stubborn at 6% for a long period of time. Hence, as the RBI gears up to announce its monetary policy decision on April 6, it needs to retain its focus on lowering the CPI inflation to the target level. The US Fed may have slowed down the pace of rate hikes in view of the latest financial market turmoil but that should not distract the RBI from prioritising domestic macroeconomic stability and inflation control.