Central banking may soon be faced with tectonic shifts
PremiumRBI should prepare for changes which may include an efficacy review of its inflation targeting model
Love them or hate them, but you cannot ignore them. Central banks have worked their way to the centre of economic and financial spaces over the past few decades, and, going by recent developments, they are unlikely to be dislodged from their privileged perches. Significant (and inevitable) changes in settled monetary-policy models or central banking practices seem to be in the offing, but the centrality of central banks is unlikely to be disturbed any time soon.
After fostering benign economic conditions for a decade—in which low inflation, low growth and cheap money became permanent fixtures—most central banks suddenly find themselves having to balance a war on inflation with attempts to maintain financial stability. One requires increasing interest rates (including withdrawing monetary accommodation), while the other necessitates providing liquidity and credit support to stressed institutions. This could be a moment of tectonic shifts, which includes a distinct possibility that financial instability might even help the battle being waged against inflation.
An elevated inflation rate has caught all central banks, including the Reserve Bank of India (RBI), on the wrong foot. Inured by the decade-long experience in advanced economies of benign or below-target inflation, most central bankers did not pay much attention when the covid-induced lockdown upended established supply chains and prices started perking up. Russia’s invasion of Ukraine added further fuel to that fire, forcing the US Federal Reserve and then other central banks to start raising interest rates at a rapid pace. Then came the Silicon Valley Bank collapse, and central banks were suddenly not smelling so good.
But even as they have been portrayed as blunderers in recent times (sample the bull’s eye painted on their backs after this month’s banking crisis), and after having dawdled initially, central banks globally still seem steadfast in their determination to bring inflation down. Leading central banks raised interest rates in tandem this month: the European Central Bank raised benchmark interest rates by 0.5% on 16 March, the US Federal Reserve by 0.25% on 22 March and the Bank of England also by 0.25% the next day.
RBI’s monetary policy committee meets during the first week of April and it is worth asking whether its members will go against the flow. So far, RBI has played a game of tag with advanced-economy central banks, mainly over exchange rate and financial stability concerns. Industry bodies have started their usual lobbying against interest rate increases.
Sanjiv Bajaj, president of the Confederation of Indian Industry, has suggested that RBI pause rate hikes to salvage manufacturing. He, however, is quiet about why private investment has remained stagnant even when interest rates were at historic lows for prolonged periods.
Paradigm shifts are usually subterranean in nature and occur even in the midst of mundane tasks. Inflation targeting could be the first among settled monetary policy goalposts to come under review. Former Bank of Japan governor Masaaki Shirakawa writes in Finance and Development, a journal published by the International Monetary Fund: “Inflation targeting itself was an innovation that came about in response to the severe stagflation of the 1970s and early 1980s. There is no reason to believe it is set in stone. Now that we know its limitations, the time is ripe to reconsider the intellectual foundation on which we have relied for the past 30 years and renew our framework for monetary policy."
In India, it is called “flexible" inflation targeting, allowing RBI to miss its target as long as the rise or fall in consumer prices stays within a specified band. But it has been over a year since India’s inflation rate has ranged above its upper limit of 6%, and RBI, instead of transparently explaining the reasons for missing the target, has clammed up. Going by past policy documents and statements, it is quite likely that RBI has exonerated itself and blames the government’s fiscal expansion during the pandemic and Vladimir Putin’s expansionary ambitions for higher inflation in India. If that is indeed the case, then it logically raises questions about the validity of inflation targeting as a reliable monetary policy tool, and whether it is fit for all seasons and reasons. This becomes moot when we consider how India’s inflation dynamic differs from the rest of the world’s, especially when weighed against a large informal economy with skewed employment and wage dynamics, or seasonally-vulnerable agri-supply chains.
Central banks have also been pilloried for lapses in their regulation of mid-size banks, which has sent ripples through the interconnected financial system. It is still early days for the advanced-economy banking crisis—which was triggered by a combination of complacent treasury practices and regulatory distractions—but all the pre-emptive action taken so far by central banks could throw up some unintended consequences.
There is a likelihood that a fear of future failures (with fresh apprehensions now roiling European bank shares) will make loan departments risk-averse, thereby affecting credit growth. Combined with repeated rate hikes, this might end up dampening aggregate demand and, as a corollary, inflationary impulses. If that happens—and there is an element of uncertainty here, given a lack of knowledge on how leads and lags work in an economy—we hope RBI will give credit where it is due for any likely fall in inflation.
Rajrishi Singhal is a policy consultant and a senior journalist. His Twitter handle is @rajrishisinghal.
Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
More Less