How the RBI innovated in unconventional ways to fight the pandemic

Several articles published recently have been unusually harsh on the RBI’s handling of inflation. Writing an epitaph for such articles reminds me of a recent interaction with RBI Deputy Governor Michael Patra at an event in Delhi. When the CEO was specifically asked about the magnitude of the interest rate hike, he recalled the story of Albert Einstein landing in heaven. When Einstein was introduced to people of all strata with very high and very low IQs, he said he would only discuss interest rates with people with the lowest IQs!

Recently, Arvind Subramanian and Josh Felman claimed that the RBI has been missing the inflation target since 2019 by not raising rates (“The RBI’s misdiagnosis”, IE, June 15). Interestingly, Subramanian, while the chief economic adviser, had taken the opposite stance by advocating for RBI rate cuts. In the economic study, he made a strong case for greater fiscal dominance stating that the RBI held large excess reserves which could be donated to the government.

Inflation was largely the result of supply-side shocks to vegetable prices, caused by crop damage from off-season rains (tomatoes, onions and potatoes) in late 2019 and widespread disruptions on the supply side after the outbreak of the pandemic. A narrow focus on inflation caused by supply shocks would have prevented the MPC from sustaining growth amid unprecedented loss of life and livelihood. Therefore, it was necessary to provide a lifeline to the economy at this stage by focusing on recovery. The MPC shifted to policy tightening to control inflation as growth impulses became more definitive and entrenched across sectors. Additionally, the wide tolerance band of +/- 200 basis points in the inflation targeting framework was specifically designed to accommodate such supply shocks, which provided flexibility in the framework. flexible targeting (FIT) (Patra and Bhattacharyya, 2022). Unlike a pure inflation targeting framework (the inflation maniacs), the amended mandate of the RBI under the FIT reads: “price stability, given the growth target” . Therefore, the MPC was justified in looking through rising inflation during the pandemic while trying to revive growth. And it worked.

Rajeswari Sengupta (“What the MPC says, what the RBI does”, IE, June 22) noted some contradictions between the Governor’s Statement (GS) and the MPC resolution.

First, the MPC highlighted inflation concerns and voted in favor of an increase in the political repo rate. However, according to Sengupta, the governor’s statement of the same day noted that the RBI will ensure an orderly completion of the government’s borrowing program. This, according to Sengupta, has caused confusion because lower inflation and lower government bond yields are conflicting goals. This justification is redundant because the orderly execution of the borrowing program does not imply lower yields. It essentially ensures that the borrowing program is completed transparently at low cost (secured by auction). Auction bids are based on prevailing macroeconomic and financial conditions. The RBI only ensures cost minimization among the bids, given that it is the statutory debt manager of the government. Moreover, from a theoretical point of view, this is not inconsistent because the control of inflation and the fall in inflation expectations bode well for the term premia of bond yields, which moderate once entrenched expectations. Therefore, if inflation is kept under control, the government has everything to gain in terms of lower interest charges.

Second, according to Sengupta, the MPC kept the repo rates unchanged while the RBI changed the reverse repo rate during the pandemic, which meant that the fixed width of the corridor was lost and the MPC lost its role in the setting of interest rates and therefore its credibility.

This argument does not stand up to scrutiny. During the pandemic, the policy repo rate was reduced cumulatively by an unprecedented 115 basis points and the interest rate on the overnight fixed rate repo was reduced cumulatively by 155 basis points. basis points. These dissimilar adjustments made the key interest rate corridor asymmetric with a downward bias. This measure was not incongruous with received ideas because an asymmetrical corridor was justified, especially in times of crisis (Goodhart, 2010). It can be noted that under normal circumstances, the reverse repo rate and the marginal standing facility (MSF) rate are mechanically linked to the key repo rate by an identical fixed margin. Therefore, any change in the policy rate automatically and symmetrically adjusts the entire corridor (without changing its width).

During the pandemic, the RBI activated other segments of the financial markets to maintain the vital flow of finance as muted demand and heightened risk aversion severed the traditional policy transmission credit channel. As elevated inflation concerns ruled out the possibility of further repo rate cuts (cumulatively reduced by 250 basis points since February 2019), financial conditions were eased significantly by reducing the repo rate reversed, which lowered the interest rate floor in the economy. Analogous to almost all central banks during the pandemic, the operational target has therefore aligned with the lower limit of the corridor instead of being in the middle. Since the mandate of the MPC is to control inflation for which the policy instrument is the repo rate, the RBI had used the LAF through changes in the reverse repo rate to alter the liquidity conditions. The intention was to reactivate the credit channel by encouraging banks to explore credit granting opportunities.

We must remember that countries that target inflation, because they only focus on inflation, experience lower inflation volatility but higher output volatility. Greater output volatility leads to a higher sacrifice ratio – the proportion of output sacrificed to reduce inflation. For an emerging economy, the lost costs of higher output against the benefits of lower inflation must always be balanced as potential output keeps changing given the shift in the production function. Developed countries, on the other hand, operate near full employment – ​​hence the sacrifice ratios are lower. Therefore, smoothing inflation volatility is relatively inexpensive for them.

The RBI has innovated admirably under its current trustees during the pandemic, keeping in mind the task of reinvigorating the economy. Despite the existing targeting framework, it did not fixate on a single-point agenda, daring to look beyond inflation. If the RBI had followed the advice of its critics in sticking to the textbooks, perhaps the Indian economy would have been in a quagmire today.

The author is Group Chief Economic Advisor, State Bank of India. Views are personal

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