How the RBI unconventionally innovated policy to fight the pandemic

Recently Arvind Subramanian and Josh Felman have asserted that the RBI has been missing the inflation target since 2019 by not raising rates (‘The RBI’s misdiagnosis’, IE, June 15). Interestingly, Subramanian, while he was the Chief Economic Adviser, had taken the opposite position by arguing for rate cuts from the RBI. In the Economic Survey, he strongly argued for more fiscal dominance by stating that the RBI was holding significant excess reserves that could be given to the government.

Inflation has been largely the result of supply side shocks from vegetable prices, caused by crop damages due to unseasonal rains (tomato, onion and potato) in late 2019 and widespread supply-side disruptions after the outbreak of the pandemic. A narrow-minded focus on inflation caused by supply shocks would have constrained the MPC from supporting growth amidst the unprecedented loss of life and livelihood. Therefore, it was necessary to provide a lifeline to the economy at that juncture by focusing on the recovery. The MPC shifted to policy tightening to control inflation when growth impulses became more definitive and entrenched across sectors. Moreover, the wide tolerance band of 200bps +/- in the inflation targeting framework was specifically designed to accommodate such supply shocks, which provided the flexibility in the flexible targeting (FIT) framework (Patra and Bhattacharyya, 2022). In contrast to a pure inflation targeting framework (inflation nutters), the amended mandate of the RBI under FIT reads as “price stability, taking into account the objective of growth”. Therefore, the MPC was justified in looking through the higher inflation print during the pandemic while trying to resurrect growth. And it worked.

Rajeswari Sengupta (‘What MPC says, what RBI does’, IE, June 22) has raised some contradictions between the Governor’s statement (GS) and the MPC resolution.

First, the MPC highlighted inflation concerns and voted to raise the policy repo rate. However, as per Sengupta, the governor’s statement of the same day noted that the RBI will ensure an orderly completion of the government’s borrowing programme. This, according to Sengupta, created confusion as lowering inflation and lowering government bond yields are contradictory objectives. This justification is redundant as an orderly completion of the borrowing programme does not imply lowering yields. It basically ensures that the borrowing programme is completed seamlessly at low costs (ensured through auctions). The bids in auctions are based on the prevailing macroeconomic and financial conditions. The RBI only ensures cost minimisation among the bids, given that it’s the debt manager of the government by statute. Moreover, from a theoretical perspective, this is not inconsistent because controlling inflation and lowering inflation expectations bodes well for the term premia of bond yields — which moderate once expectations are anchored. Therefore, if inflation is reined in, the government stands to gain in terms of lower interest costs.

Second, as per Sengupta, the MPC kept repo rates unchanged while the RBI changed the reverse repo rate during the pandemic, meaning that the fixed width of the corridor was lost and the MPC lost its role in setting interest rates and so, its credibility.

This argument does not stand scrutiny. During the pandemic, the policy repo rate was cumulatively reduced by an unprecedented 115 bps and the interest rate on the overnight fixed-rate reverse repo was reduced cumulatively by 155 bps. These dissimilar adjustments rendered the policy interest rate corridor asymmetric with a downward bias. This measure was not incongruous with contemporary wisdom as an asymmetric corridor has been justified, particularly during crisis times (Goodhart, 2010). It may be noted that under normal circumstances, the reverse repo rate and the marginal standing facility (MSF) rate are mechanistically linked to the policy repo rate by a fixed identical margin. Hence, any changes in the policy rate automatically, symmetrically adjusts the entire corridor (without changing its width).

During the pandemic, the RBI activated other segments of financial markets to keep the lifeblood of finance flowing as muted demand and heightened risk aversion broke down the traditional credit channel of policy transmission. Given that elevated inflation concerns precluded the possibility of any further repo rate cuts (cumulatively reduced by 250 basis points since February 2019), financial conditions were eased substantially by reducing the reverse repo rate, which lowered the floor rate of interest in the economy. Analogous to almost all central banks during the pandemic, the operating target thus aligned with the lower bound of the corridor instead of being in the middle. Since the mandate of the MPC is to control inflation for which the policy instrument is the repo rate, the RBI had used the LAF through changes in the reverse repo rate to alter liquidity conditions. The intent was to reactivate the credit channel by encouraging banks to explore opportunities for extending credit.

We must remember that inflation-targeting countries, because of their sole focus on inflation, experience lower inflation volatility but higher output volatility. Higher output volatility entails a higher sacrifice ratio — the proportion of output foregone for lowering inflation. For an emerging economy, the costs of higher output foregone against the benefits of lower inflation must always be balanced as potential output keeps on changing given the shift of the production function. Developed countries, on the other hand, operate near full employment — therefore, sacrifice ratios are lower. As a result, smoothening inflation volatility is relatively costless for them.

The RBI has innovated admirably under its current stewards during the pandemic, keeping in mind the task of reinvigorating the economy. Despite the existing targeting framework, it did not get fixated on a one-point agenda, daring to look beyond the inflation print. Had the RBI followed the advice of its critics by sticking to textbooks, perhaps the Indian economy would have been in a quagmire today.

The writer is Group Chief Economic Advisor, State Bank of India. Views are personal