Monetary policy in the absence of a divine coincidence

Monetary policy had shifted gears quite some time earlier to support growth. This was easier when inflation was well within the target range. But, while growth continuing its downward trend, inflation started picking up at the end of 2019 mainly due to high food prices. The latest inflation and growth figures are quite alarming, though. While consumer price inflation for June, July and August stood at 6.23%, 6.73% and 6.69%, respectively, well above the upper tolerance limit, India’s gross domestic product data for the first-quarter of 2020-21 released by the Central Statistics Office showed a record 23.9% contraction. While we await more reliable data on inflation, it seems certain for now that the economy is headed for negative growth over the full year. The present stagflationary scenario raises concerns that monetary policy will be constrained in its efforts to support growth as long as inflation stays above comfort levels.

Covid is primarily a health shock that triggered both demand and supply-side disruptions in the economy. On the face of it, a negative demand shock and an ensuing recession should result in falling prices. However, the dominance of negative supply shocks over demand at this juncture may have led to rising prices at a time output is falling. Note that in India, the prevalence of supply shocks has been a dominant factor in determining the inflation trajectory.

The way monetary policy responds to the evolving growth-inflation dynamics depends largely on the underlying monetary policy framework. India operates under a FIT framework, whose main objective is to achieve 4% inflation as a target for the medium term, while addressing growth concerns in the short-term.

It is important to understand how an inflation-targeting central bank would respond to stagflation that occurs due to dominant negative supply shocks, like those caused by covid. Also note that monetary policy is ideally used mainly to manage aggregate demand. Its efficacy is restrained when a supply shock hits the economy.

Under an inflation-targeting framework grounded in New Keynesian theory, a “divine coincidence" is an ideal situation. When a positive demand shock, such as an increase in government spending, reaches the economy, both output and inflation rise. Since output and inflation move in the same direction, attempts to curtail inflation would stabilize output as well. This outcome is called a “divine coincidence" in economics, as stabilizing inflation also stabilizes output, and there is no trade-off between output and inflation objectives. However, this coincidence rarely occurs. Emerging market economies like India are frequently hit by temporary negative supply shocks, like food and fuel price spikes, which move output and inflation in opposite directions, resulting in high inflation and low output. Consequently, that coincidence vanishes, as stabilizing inflation is not equivalent to stabilizing output, and an attempt to curtail inflation worsens the output loss. Monetary policy thus faces a dilemma, or trade-off; namely, whether to choose output over inflation. India’s present inflation-output scenario captures this dilemma.

Monetary policy needs to do a balancing act when a trade-off between output and inflation presents itself. The role of policy credibility and its anchoring of inflation expectations gains significance here. If medium- to long-term inflation expectations among households are anchored firmly around the target, the policy could accommodate high inflation temporarily to address immediate growth concerns. To achieve this, though, these expectations should be resilient to temporary supply shocks. This would happen only if the policy prevents the second-round effects of relative price shocks by committing itself to its medium-term inflation target. RBI’s surveys indicate that though household inflation expectations dropped sharply after the adoption of the FIT framework, they are still above 6%. With retail inflation expected to be at elevated levels for at least a few months ahead, anchoring expectations will be a challenge.

The Indian economy is susceptible to adverse supply shocks that create a dilemma for monetary policy. Since our policy framework is under review and its inflation target may be revised next year, this seems like an appropriate time to discuss the feasibility of including an “escape clause" in the framework to deal with such shocks as covid.

Bhavesh Salunkhe is a fellow at Mumbai School of Economics and Public Policy (Autonomous), University of Mumbai.