Policy credibility

Monetary policy framework should not be undermined

The spread of Covid-19 and the ongoing lockdown have affected economic activity significantly, with many economists expecting the Indian economy to contract in the current fiscal year. These projections are likely to worsen as it is still not clear when normalcy would be restored. A taste of things to come was evident on Wednesday, when the US announced that its economy shrank at an annual rate of 4.8 per cent in the first quarter, the steepest contraction since the last recession. The worst is obviously yet to come, with many analysts terming the first-quarter numbers as the tip of the iceberg. So far the Indian government has announced only a Rs 1.7-trillion package for the most vulnerable section of the population, and most of the heavy lifting has been left to the Reserve Bank of India (RBI), which has reduced interest rates and flooded the system with liquidity. The banking system currently has excess liquidity worth about Rs 7 trillion. While excess liquidity has not eased pressure in the financial system to the extent desired, it is possible that some of the recent policy decisions of the central bank may end up creating longer-term risks.

In this context, in a recent article published in The Indian Express, former RBI governor Urjit Patel has rightly cautioned against diluting the monetary policy framework. Policymakers, both in Mumbai and New Delhi, would do well to take into account the unintended consequences of some of the recent policy measures. As Mr Patel noted, even when the monetary policy committee (MPC) in recent times decided to keep the policy rate unchanged, the RBI increased liquidity in the system to influence medium-term rates. If the idea is to bring down medium-term market rates, it should be done through building a consensus in the MPC to cut policy rates aggressively with proper explanation. Also, the RBI recently reduced the reverse repo rate outside the MPC cycle, which was until then part of the MPC resolution. With so much liquidity in the system, market rates are now essentially being controlled by the RBI and not the rate-setting committee. Undermining the MPC can increase financial stability risks, especially in uncertain times. 

There are strong reasons why the sanctity of the monetary policy framework should be maintained. For instance, in the given economic environment, it is likely that policymakers would need to take some extraordinary measures. In such a situation, it would be comparatively easy to convince financial markets that such measures will be rolled back in time if they are done transparently through proper institutional mechanisms. If the markets start believing that institutional structures and checks are being undermined, financial stability risks could go up substantially.

The adoption of the inflation-targeting framework has served India well, and is seen as one of the biggest reforms in recent years. There is no reason why it should not continue to be followed. Although there is a broad consensus among economists that the demand shock induced by Covid-19 will keep inflation low in the foreseeable future, disruption in supply-chains and global trade could push up prices in the interim. While higher inflation could be transient in nature, it could affect inflationary expectations if the credibility of the monetary policy framework is dented and make macroeconomic management more difficult. To be sure, these are extraordinary times and policymakers may need to take unconventional measures. But it will be critical to protect the credibility of institutions.