Monetary policy alone won’t bring down inflation

After months of exhortation by the market and being criticised for falling behind the curve, the Reserve Bank of India (RBI) last week raised both policy rates and cut back liquidity in a surprise inter-meeting decision. The forcefulness and urgency of the policy shift have been welcomed by analysts and the market alike and seen as a signal of the RBI’s renewed commitment to fighting inflation via aggressive monetary tightening in the coming months.

But is this the right policy path? I am sure that many readers are surprised at the naivety of the question, especially as we appear to have been influenced by the global frenzy of seeing inflation fears everywhere. It is true that a large swathe of the global economy is in the throes of runaway inflation and that in many of these economies tightening monetary and fiscal policies is the right response. But initial conditions matter as do the specific drivers of inflation.

To break down the question, let me ask an even more naïve one: How do higher interest rates slow inflation? There are typically three ways. The first is by lowering inflationary expectations. Suppose one believes that because a central bank has not tightened enough, future inflation will be higher. In that case, the obvious response is to bring forward future consumption and investment to the present, thereby adding to demand and fueling current inflation further. So, in principle, the central bank by credibly committing to bringing down inflation through aggressive current actions can bring down expectations of future inflation. If that happens, then demand would be pushed back, alleviating current inflation. This is a very potent conduit of monetary transmission in developed markets, where there is a wide variety of inflation-hedging instruments, as well as in some emerging markets — Brazil, for instance —where inflation-indexation is widespread. However, there is little empirical evidence that this channel works in India, even weakly.

The second route is via the exchange rate. Higher interest rates attract foreign capital that appreciates the currency, lowering import prices and, in turn, inflation. Again, this is a powerful mechanism in Latin America and Central Europe, where bond flows — that are sensitive to interest rate differential —dominate capital movements and the import content of the consumer basket is large. This is not the case in India and, in any event, for this to work it would require extreme rate hikes in the country, given the anticipated aggressive tightening by the US Fed.

The third, and the most relevant channel for India, is via curbing credit growth. Raising both the cost of borrowing as well as its availability (for example, by increasing the cash reserve ratio) reduces credit growth, lowering demand, GDP growth and, eventually, inflation. This is the credit transmission by which higher interest rates dampen inflation and it works well in India.

The question is how much of today’s price increase is credit-driven, such that curbing it would lower inflation? Even a cursory glance at bank balance sheets would suggest that credit growth is just treading water. Having recovered from being negative in mid-2021, real credit growth is running just around 2 per cent (deflated by CPI and even less if a broader measure of inflation, such as the GDP deflator, is used).

Some analysts have pointed to the inflation-monetary policy dynamics of 2010-11 as to why the RBI needs to act aggressively and early this time around. This is when differentiating the specific initial conditions matters. Back then, real GDP growth was clocking over 10 per cent per quarter, nominal credit growth 20-25 per cent, and real credit growth over 10 per cent. Inflation was unambiguously driven by an overheated economy and fueled by runaway credit. At that time, as pointed out repeatedly by some of us, hiking rates aggressively and quickly could potentially have delivered a soft landing of 7-8 per cent real GDP growth by curbing borrowing sharply. In the event, the RBI assessed the drivers of inflation to be originating from the supply side — higher food and commodity prices — and moved at a glacial pace, such that even after 12 rate hikes inflation remained in double digits for much of that period. The overheating festered and external vulnerabilities widened. Faced with a potential US Fed tightening in 2013, India found itself in a near-crisis situation.

Today things are different. Much of the inflation is driven by global food and commodity prices. While the level of investment has just about recovered to its pre-pandemic level, consumption remains stubbornly below. Despite the languishing private demand, core inflation remains high. But this has been the case for much of the last two years, strongly suggesting that the domestic supply chain disruptions in manufacturing and services, especially at the informal level, haven’t been repaired fully. While some of the disruptions have been eased by an ongoing formalisation of the economy, this too is adding to inflationary pressures. The reason why firms locate in the informal sector in the first place is because of lower transaction costs, so when parts of the supply chain shift to the higher-cost formal sector, it shows up as inflation during the transition before increased scale of production and efficiency bring down the cost over time. None of these factors is affected much by higher lending rates. So the burden of taming inflation by tightening monetary policy will fall largely on lower credit. This will inevitably make the required decline in credit growth that much larger. And with that its cost — the attendant fall in GDP growth.

There is clearly a case to remove the extraordinary monetary support provided during the pandemic. Perhaps the RBI should have moved earlier in doing so. However, removing emergency accommodation is one thing and relying solely on culling credit growth — which is barely positive in real terms — to tame inflation is completely different that can cost the economy dearly. The RBI had misread the drivers of inflation badly in 2010-11. Hopefully, it won’t repeat that mistake this time. Bringing down today’s inflation requires a resolution of geopolitical tensions in Europe, changes to China’s zero-Covid policy, much stronger fiscal support from the government, and reforms that help repair the disrupted domestic supply chain. Not just monetary policy.

This column first appeared in the print edition on May 13, 2022 under the title ‘Don’t leave it to RBI’. The writer is Chief Emerging Markets Economist, J.P. Morgan. These are the author’s personal views

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