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How the three members in the new MPC plan to track CPI inflation

Topics MPC | MPC meet | RBI

Illustration: Ajay Mohanty
None of the three members of the new Monetary Policy Committee are too hot on tracking the Consumer Price Index-based measure of inflation for their analytical perspectives. The members have begun their meetings today to offer their assessment of how the rates should move. The three-day meeting will be over on Friday. 

In her analysis of inflation in India, Ashima Goyal has drawn attention to the role of price discovery in the G-Secs market as a determinant. She says this matters when bank credit is thin and there is a high level of borrowing by the government, a phenomena all too apparent this year. 

This is different from the current RBI position where it draws most of its inferences on how inflation would behave from the consumer price index (CPI). Based on the movement in the CPI, the Bank sets the rate and the markets react, sending the prices of the government securities up or down. If the CPI hardens for instance, the RBI could decide to suck out cash from the economy and that, in turn, could raise the prices of G-Secs.

Goyal has argued that “price discovery in longer-term G-Secs gives an estimate of macroeconomic variables such as expected inflation and growth” in a paper last year. (Government securities market: Price discovery and the cost of Indian government borrowing, July 2019). Does it make her a dove in inflation targeting? At the very least, it offers RBI the space to consider a more sympathetic understanding of the needs of the government than it would just by examining how retail inflation has played out in the economy. 

While she has explicated this theme in the recent paper, she has made her choices clear on how to respond to the sort of inflation that India is facing in an earlier paper as well. “The first best policy response to a temporary supply shock is to shift down the supply curve by neutralising mechanisms that propagate supply shocks, while avoiding too large a demand contraction” (Understanding High Inflation Trend in India, May 2015)

She goes on to say that “a standard monetary tightening to anchor inflation expectations requires a large growth sacrifice”. It is usually rare for monetary economists to offer such a sympathetic ear to what the finance ministry says. To that extent the IGIDR professor is a minority, trying to balance inflation with growth concerns. 

Interest rate-setting issues have been examined more as a structural issued by the other member of the Monetary Policy Committee, Jayanth Verma, professor at IIM. Just before the period when Governor Shaktikanta Das had wondered aloud how low India could afford to push interest rates, Verma had explored the implications of negative interest rates and what it does for bank balance sheets (Finance in a World of Negative Rates, 2016). 

In an earlier paper, examining the interest rate dynamics, Verma has argued that volatility of short-term interest rates in India could be seen as “high by international standards, but are quite close to the Japanese experience”. In fact it is this deep understanding of the structural issues that are often left untreated in the credit market which has dominated his work on the financial sector. This includes not only some of the frontier challenges but also perennial attractions like development financial institutions. 

On the use of blockchain on which the RBI has yet to come up with a clear position, he notes that the technology it could take decades to stabilise its role beyond its use as currency. “History teaches us that radically new technologies take many decades to realise their full potential. Thus it is perfectly possible that blockchain would prove revolutionary in the years to come despite its patchy success so far. What is certain is that businesses should be looking at this technology and understanding it because its underlying ideas are powerful and likely to be influential,” Verma says. (“Blockchain in Finance”, 2019).

He rightly cautions that exuberance to set up DFIs could be meaningless unless “difficult questions about management and governance” are addressed. “Old performance measures like loan disbursements, profits and contribution to priority sectors are meaningless and irrelevant”, Verma adds. While the MPC is unlikely to be consulted by the finance ministry if it does go ahead with plans to set up a new DFI, the bleak assessment about their utility from the committee could temper enthusiasm. 

Examining the role of interest rates more from the sectoral perspective, Shashanka Bhide, Señior Adviser (research programmes) NCAER has argued that the link between reduction of the rates and that of economic growth “would not be dramatic” (Financial Exuberance, 2001). However it should be noted that this is a work from an earlier era, with Bhide now having moved on to detailed examinations of poverty, a subject often neglected, but which has obviously come back into the limelight. An important perspective he brings is that the same segment of population does not remain poor all the time. 

“Entry into poverty traps is explainable by sudden financial crises” or similar shocks, he shows using panel data from different decades of Indian economy. The escape routes, he argues, include “Urbanisation, infrastructure, education, good health, and geography (say migrations from rural to semi-urban, to urban) are the ladders to escape from poverty”. (Poverty, Chronic Poverty and Poverty Dynamics: Policy Imperatives, 2020). It is this perspective which could dominate Bhide’s approach to interest rate setting, making it neither too hot nor too cold for the poor to use profitably. 


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