By Renu Kohli
The October review of monetary policy caused fundamental confusion—on the one hand, rate and stance remained unchanged, while on the other, it was indicated that policy space had opened for further growth support due to prevailing macroeconomic conditions and outlook. The Monetary Policy Committee (MPC) awaited more clarity on uncertainties about trade, playout of past rate cuts, and fiscal measures.
The hesitation in monetary action generated multiple understandings about the economy’s state relative to the cycle, compounding inconsistences about demand signals and the positioning of macroeconomic policies. Since then, September’s inflation data, below quarterly forecast (1.7% versus 1.8%), moderated consensus expectations for October inflation (~1%). Markets have now raised the probability of more easing in December. Can the MPC deliver?
Against its October resolution, the committee will undoubtedly appraise monetary transmission. There are two bottlenecks here. One, bond yields, which hardened after June’s 50-basis point (bps) reduction reflecting fiscal risk, remain so. Two, banks have been raising fresh loan rates by increasing spreads to protect interest margins and offset reductions on external benchmark-linked or existing loans. Easing too much, too fast, has pushed them into this corner.
This is a direct consequence of the external benchmark lending rate (EBLR) system. In a tightening cycle, interest margins aren’t squeezed because all lending rates immediately rise while deposits, contracted at lower rates before, take longer to reprice. In the reverse or easing cycle however, banks are forcibly hit because ~63% of floating rate loans are EBLR-linked with immediate passthrough of the revised (lower) policy rate; on the other side, the bulk of bank deposits are contracted at past (higher) rates and take much longer to climb down, resulting in the disguised increase in fresh lending rates.
The MPC will have to weigh these developments against the risks of further easing. What are these? Fiscal risks to the bond market cannot be ignored. There are no signs of fiscal pressures abating, seeing revenues and nominal growth trends. It is the elephant in the room. How could banks respond? They could raise fresh loan rates further, defying the policy cue. Or, if forced to lower deposit rates, it would risk the savings-investment balance. Margin and profitability pressures persist—banks could take two more quarters to align funding costs. Therefore, further policy easing risks destabilisation. The signs are that the cycle may have bottomed out.
Next, the MPC minutes have illuminated demand uncertainties. One internal member (I Bhattacharya) cautioned that “monetary policy has to be cognisant of potential demand pressures over the medium term”. External member (R Singh) warned of “overdose” but argued for shifting of stance (accommodative) to sustain the growth momentum, with external member N Kumar. All others disagreed on future commitment, unsure of demand.
At the heart of this hesitation is the output gap. Where exactly does the low core inflation align with the 6.4-6.7% growth range, realised and forecast? The clarity on policy space indicates the current real rate, set at 1%, is restrictive; inflation and growth are projected rising to 4.5% and 6.4% respectively three-quarters ahead. Against the commonly believed potential growth (6.3-6.7%), a minor negative output gap is perceived over the current policy horizon. This would correspond to the apprehended “demand pressures” and “overdose”, otherwise inconsistent with policy space availability.
What are the real issues not considered by the MPC? The real problem is the output gap.
The Reserve Bank of India’s (RBI) sense is unknown. True, it has traditionally shied away from any specific approximation, reserving its potential growth estimate. Although unobserved, potential output is nonetheless extracted with various methods, usually from past trends. As any observer of Indian monetary policy would know, such evaluations of the output gap were plotted with explanatory sub-sections in the monetary policy reports.
The depth could be gauged and even a crude number read off the axis, helping understand interest rate adjustments in response to inflation and output. After April 2020, however, both stopped. Understandably, during the pandemic, it was difficult to base monetary policy upon the conventional, rules-based reaction function because estimating potential output was impossible at the time. Since then, however, the economy and macroeconomic policies have normalised. If an inflection point is reached, or is near, it is essential to know. The presumed output gap and an idea of potential growth are necessary. The central bank seems unsure of what India’s potential growth capacity may be. Clearly, it must know if fundamentals have changed and recalculate.
What creates policy space, meriting an ultra-low real interest rate in this light? A real rate below 1% disregards the RBI’s indicated comfort range of 1.5-1.9%. Bond and credit markets signal bottoming out. Fiscal policy is massively trying to boost consumption. Monetary efforts are complementing to buoy investment. At a time when India is powering fastest in a low-growth world, the risks are high.
This is not 2019-20, when real GDP growth plunged to 3.9% from 6.5% the previous year following the non-banking financial companies’ crisis. Even then, the real policy rate was not 1%, leave alone below. Between February-October 2019, monetary policy eased by 135 bps to 5.15%, yielding real rate range of 1.3-2%, depending on the last inflation print or an average.
We can turn this around to ask when was core inflation this low. Conditional upon the measure, this too was the last quarter of 2019 or month of December 2019. Yet another guidance is theoretical. The real or neutral rate is one that balances savings and investments. It shifts with permanent changes in the supply of savings and demand for investments—that is, rising if savings decline or investment demand increases, shifting downward with the opposite.
We know that investment demand has fallen and remained depressed for longer than a decade. The savings rate is declining too. Whereas the positive circular feedback between the two, i.e., the multiplier, never materialised. How this affected the economy’s productive capacity or potential output is the moot question. These are different perspectives. They do not help us determine the optimal policy rate, which is assessed from deviations of inflation from target and the output gap. The “aspirational” or “aspired” growth is seriously disconnected from these technicalities of monetary policy rules, of which potential growth is a critical component. The RBI’s silence does not help. The output gap should be clearly spelt out.
The writer is a senior fellow at the Centre for Social and Economic Progress
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