Monetary policy enters difficult grounds

By: |
October 20, 2021 4:00 AM

RBI must appropriately communicate its demand-condition readings; analysts are differing significantly with it

So, RBI has a difficult job at hand—try to convince markets and bring them around to its assessment of the output gap. It needs to clarify better than it has in the statement and post-policy conference.So, RBI has a difficult job at hand—try to convince markets and bring them around to its assessment of the output gap. It needs to clarify better than it has in the statement and post-policy conference.

Gauging the strength and durability of demand recovery from the pandemic depths is challenging central banks the world over. Even those with singular data on unemployment permitting multidimensional insights are prone to misgivings due to distortions induced by the pandemic, unsure of their protraction, and wary of unknown ones. Most worry about erring on the side of caution, preventing policy adjustment in line with evolving recoveries; others with lesser capacities are compelled by the lack of choice. Unlike markets and analysts who tend to be surer, central banks are more persuaded to wait, watch and confirm the early rebounds will not dissipate.

The understanding of macroeconomic conditions is tougher because of sudden shortages, bottlenecks, supply chain breakages and unstable new formations, geopolitical obstructions, jump in energy costs and other prices; such troublers increase apprehensions about more in the offing. Informed guesses on the clearing of supply issues are speculations at best. As result, no central bank is able to assess demand with sufficient confidence, usually possible for monetary policy in normal upswings.

Viewed in this light, Indian monetary policy is possibly at an inflection point in more ways than apparent from the start of liquidity normalisation announced by RBI on October 8. A quarter ago, the dominating apprehension was of igniting inflation from several sources within ultra-loose monetary conditions ( The anticipated pressures did not materialise however, creating doubt if demand was correctly assessed. In fact, the pendulum swung to the other side—either demand was deeply depressed or the output gap was more enlarged than believed before (

This evolution, reflective of similar challenges faced elsewhere, is now critically poised: Lurking in the background of gradual normalisation of surplus liquidity is the precise state of demand.

In its policy review, RBI made it clear that halting the GSAP did not mean a steep reduction in liquidity and assured a gradual, non-disruptive rowing to the ‘visible shore’. The central bank also retained its accommodative stance for as long as necessary to revive and sustain growth on a durable basis and mitigate the Covid-19 impact upon the economy, while ensuring inflation remains within target ahead.

There’s a noticeable segregation RBI has made between repatriation of excess liquidity and standard monetary policy or interest rate changes. Some might draw a parallel with the US Federal Reserve, which successfully delinked its asset purchase rollback from interest rate increases, with the latter still distant at this point. The similarity is irrelevant to the policy discourse, but the distinction is not. Central to this is the size of the output gap, and differing assessments of RBI and those of the markets and analysts. If there was a tussle between the two on inflation readings not so long ago, that is now about the demand gap and speed of its closure.

Markets and most analysts believe the output gap is closing very quickly, way beyond the expected speediness; therefore, inflation risks cannot be ignored and RBI would be falling behind the curve if it does not begin to normalise monetary policy along with liquidity, which has a long way to go given the size of surplus. Most think the policy rate should be raised sooner than presently communicated by RBI; else, the fast-recovering demand could override the gap. In other words, liquidity normalisation alone is not sufficient to dispel the inflationary risks.

Obviously, these beliefs are at variance with the central bank’s view, which it has communicated and acted upon through decoupling the excess liquidity removal from interest rate adjustments. RBI’s attempt is to remove the excess liquidity impact upon interest rates through normalising the former without any change in the policy rate. But the markets are driven by demand optimism. Therefore, their ‘policy’ expectations could push up interest rates beyond what the central bank desires or comfortable with.

Is RBI right or the markets are? There is ambivalence on the central bank’s part: its 9.5% GDP growth projection is unchanged with a steep, 40 basis point reduction in the annual inflation forecast, but the actions suggest either it is unsure of or not fully convinced the recovery is securely rooted after exit from the pandemic. When asked about this disparateness in the post-policy call, the RBI Governor noted there was unevenness; growth, he said, was nowhere near desired levels, the slack or the output gap persisted, and RBI was looking for signs of its resilience and entrenchment. In an earlier speech, Deputy Governor Patra had stated the output gap was bigger this year than the preceding one.

The output gap is very subjective; potential output, from which it is derived, is not directly observed. RBI never specifies this exactly. And analysts have their own respective estimates of potential output. The interpretation of the output gap therefore becomes very important at this stage, especially in times such as emergence from a pandemic-caused recess and even more so in countries like India that have no rigorous or timely data on unemployment. It is possible to logically say in the same breath that four-fifths of India’s workforce is engaged in the informal sector and we know nothing about its condition!

So, RBI has a difficult job at hand—try to convince markets and bring them around to its assessment of the output gap. It needs to clarify better than it has in the statement and post-policy conference. Otherwise, the brimming demand optimism could overwhelm the liquidity withdrawal effect on interest rates prematurely and prevent the central bank from remaining accommodative for as long as it judges is necessary.

The idea of going gung-ho on growth optimism all around is leading to ebullient market expectations about strength of the recovery. It has repercussions in creating a conflict for the central bank, which too cannot easily hold its 9.5% real GDP forecast and at the same time say that growth is very fragile, requires support. Or that the output gap is very large. Settling this conflict is the inflection point for monetary policy. Not an easy task by any means. Ask any central bank.

New Delhi-based macroeconomist

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