Subdued credit growth is a bigger concern than rising inflation. Time for the MPC to shed light on this inability to revitalise demand
It said that the food inflation stood at 7.48 per cent in November as against 8.21 per cent in the previous month. Food inflation was at 9.87 per cent in the year-ago period.
With the October assurance to stay the course until April-June 2021, see-through supply-driven inflation, now above-target for a year, there is little fresh monetary impetus that can be expected in the forthcoming review. The commitment rides over any discomfort about surging food inflation that has upended softening predictions, defied last year’s high base; some non-food prices are also inclining up, while core inflation is yet to match the deeply negative output gap. Price developments since October yield no scope for further growth support. It is a time to wait for the exceptional measures to impact with the continuous economic reopening. What stands out is the absence of credit response to all monetary actions, before or after Covid-19, standard and otherwise. It is also, therefore, time for the MPC to shed light on this inability to renew demand. Compared to the exceptional success claimed in controlling inflation, this failure is a stark contrast.
First, the inflation developments, on which, no doubt there will be uneasiness. At 11% year-on-year the last two months, CPI food inflation has not softened as was especially expected from October. It is broad-based across vegetables, pulses, edible oils, spices, protein foods, overall foods and beverages with double-digit increases over similar price increases last year. With much unlocking, it is inexplicable that the pandemic-induced constraints are still pushing up food prices. Reasons appear more unique, eg, inclement weather (vegetables), high import duties and below-potential global production (key edible oils, where import duty was recently reduced), import curbs, reduced inventories from free distribution/public welfare programmes, random crop damage (pulses), demand-supply mismatches (protein foods), according to reports.
The pandemic has also turned around spending habits, something observed universally. Except that elsewhere, eg, advanced economies, food price pressures (also some staples) are believed to be hidden, not captured in official measures where weights are unchanged. To account for such distortions, some researchers have recalculated weights to construct a ‘lockdown CPI’ (the UK) or Covid-19 inflation measure (the US) to know real food inflation. Recent IMF research finds huge disparities in official and actual price pressures experienced by consumers; the main causes of inflation underestimation are the under-weighting of rising food prices and over-weighting of falling transport prices.
India, on the other hand, has visibly throbbing food inflation. With almost half the consumer price index formed by foods, this probably reflects any thrust from spending changes. The central bank is unlikely to be too perturbed about high food inflation, point to supply-side developments and difficulties in checking food prices in a pandemic, and reiterate expectations of decline from December when the statistical impact is very strong.
The concern rather is this: Will the high food inflation transmit to the core? Above 5% for the last four months, core retail inflation is two percentage points above that in October last year. But its momentum has trended down after July; the downward incline should sustain because of the massive negative output gap should sustain. The labour market slack is enormous; incomes of many employed persons stand reduced, implying little bargaining power for wage adjustments. The probability of producers passing on raised input costs in such depressed circumstances is minimal: although world industrial prices have shot up on a monthly basis and relative to last year, reflected in domestic price movements, the changes are still negative or 1-3% except in basic metals (5.3%).
The sub-2% core inflation at the wholesale level is proof of how depressed demand is. These signs do not portend the risk of second-round effects sparking generalised inflation. Especially, with doubt that initial recoveries in sales and activities may not sustain.
Returning to monetary policy impacts, bond vigilantes are evidently restrained by October’s monetary reinforcements. The 10-year benchmark bond yield is restricted, passive within 5.8-5.9%, and RBI can rightfully claim success for this. Problems have surfaced at the short-end though: capital and current account surpluses and resulting intervention has compounded liquidity pressures with excess reverse repo deposits nearly Rs 1 trillion higher on average in one month.
While the TREP rate was treading below reverse repo (3.35%) for some months, the weighted overnight rate slipped under last month; last week, the 90-day tenure money joined in the 3% region. Even as the yield curve has shifted lower, it has steepened with term premia above 250 bps.
These developments have prompted a view on withdrawing some accommodation to anchor the short-term rate. Maybe, maybe not. Monetary aggregates show no signs of lighting up: brisk growth of net foreign assets is offset by slowing net credit to government, which contracted last two months; net reserve and broad money growth is limited; money multiplier subdued while velocity continues to fall. As long as inflation risks remain dormant, RBI can bear these pressures. The only fallout is the mounting cost of sterilisation. But, the government is borrowing cheaply so the bargain with lower dividend payout next year is hardly unpleasant.
As result, banks have been reportedly giving long-term loans at sub-market rates to blue-chip borrowers. At another level, some borrowers too, are reportedly repaying loans through cheaper bond and commercial paper issues. Ideally, banks should lower deposit rates. But, there are arguments of hurting savers whose deposits fetch negative returns already. Contrast this with the real interest rate paid by producers—above 2%, no less, in the deepest recession in living memory! The choice to unwind, reduce outstanding bank credit, and not borrow anew is not surprising in this light. Monetary policy has to be especially careful about producers in a recession. But, the official framework targets headline consumer price changes.
The inability of monetary policy to impact aggregate demand, its ultimate goal, and revive the economy is glaring. Despite the armoury of deep interest rate cuts, special liquidity and open market operations from early 2019 or much before Covid-19 struck, and more fortifications thereafter, credit demand has not renewed up but decelerated: If banks were loaning 78% of their deposits in March 2019, they progressively loaned less, 76%, before Covid-19 arrived; post-Covid, this is down to 72%. All the monetary bullets, which include forcing banks to link their marginal cost lending rate (MCLR) to repo rate in October 2019, could achieve was a 6.7% growth in bank credit in FY20, half that in FY19 (12.3%)!
Without or with the virus attack, credit demand has not perked up. The inescapable conclusion is that monetary policy failed to revive the economy despite its success claimed for taming inflation. And, now that inflation is under pressure, monetary policy continues to accommodate and is still unable to motivate activity. It is quite likely the ammunition is now severely depleted. So a wait and hope for revival is the best course.
The failure of monetary policy to restart growth is not too different from monetary policy failures elsewhere, for example, the advanced countries. The difference is the latter have no inflation while India has inflation and no growth! It is time the MPC focuses on these aspects.
Author is a New Delhi based macroeconomist Views are personal