This piece of writing is the first article of the four article blog series. The series of blogs will try to asses’ monetary policy effectiveness during pandemics. The first blog will be covering the extent of the effectiveness of the policy. The second blog will throw light upon the interaction of the monetary policy and the financial markets. The third article of the blog series would elucidate the role of modern monetary policy. And the final article will be a concluding article and suggest some alternative tools to tackle financial crises.
The economic impact of the covid-19 pandemic has been considerably disruptive in terms of jobs and economic activity. India’s annual economic growth has gone down by 7.3 percent in FY21, eventually a substantial erosion in the GPD. India was witnessing a sluggish growth in the pre-pandemic period; the first pandemic wave slowed it down notably and subsequently the second wave joggled it down for a further slide. The economic growth in the first quarter of FY 22 is 20.1 percent, as against the 26.2 percent decline in Q1 of FY 21. What is discouraging here is that RBI, after seeing the performance of the first quarter of FY 22, has restricted its growth projection to be at 9.5 percent as against earlier estimates of 10.5 percent. In this journey of poor economic growth in the pandemic period, the country is getting troubled into a difficult labour market and a fractured MSME sector.
In this rough period, the middle class has stopped spending as compared to what they were doing in the pre-pandemic period. This has led to a decline in production due to lower demand. For example, production in the automobile sector has been reduced by 27.3 percent in the last two years, and similar is being felt in many other sectors of the economy. The firms which had cash on their balance sheet and also had a global presence along with a diversified sale portfolio geographically are in a beneficial position. In the way just indicated, what is more distressing in long run is a unique phenomenon that the big firms are getting bigger and the small firms smaller. The bigger firms, with time, are eating away smaller firms’ shares. In the long run, this process is inducing inequalities amongst firms.
Business cycles of recession and boom in an economy are inevitable phenomena. ‘Recession’ is marked by falling in output and employment, whereas at the other end of the spectrum, an un-sustained economy characterized by higher inflation is called a ‘boom’. During recently, when financial markets are growing at a rapid pace in a visible size, in an environment of apprehension of increasing debt to GDP ratio along with growing sustainability issues, many governments tackle recessions with monetary policy rather than a fiscal one. Monetary policy set in by the Reserve Bank of India (RBI) to fight recession is a counter-cyclic and proactive manner with a bunch of specific goals as set out by the RBI.
This is not the first-time use of this policy in a recessionary economy. Historically there has been a successful use of monetary policy by many central banks including the Federal Reserve System (Fed) and European Central Bank (ECB). During the sub-prime crisis-global financial crisis (GFC) between mid-2007 and early 2009- many central banks adopted a dovish monetary policy to increase equity in the market to boost output and stabilise inflation to alleviate financial distress. Nonetheless, according to some research findings, output and inflation remained lower than expected in many countries and recoveries were perceived a little sluggish.
Reserve Bank of India’s monetary policy revolves around changing policy rate – a rate at which RBI lends money to commercial banks- to adjust the supply of money in the economy to finetune its macro-level indicators. The monetary policy is either contractionary or expansionary. This theory is primarily based on the thesis that in the long run, output measured by gross domestic product is fixed, thus any supply in money only results in a price change. Nevertheless, in the short-run price and labour wages take time to adjust, any changes in money supply can cause changes in the production of goods and services and ultimately employment level. This implies that the prime objective in the long run of any monetary policy is to affect prices i.e. inflation, yet keep the objective of growth in mind.
In normal time, theoretically, a counter-cyclic policy – an expansionary in a recession and a contractionary in a boom period – would guide to the expected expansion or contraction in the economy in terms of output and employment level, simply because it brings about an increase or decrease in the supply of money to cause definite changes. During the recession, it should increase the demand for goods and services and ultimately put pressure on the cost of inputs and labour wages, seriatim, an increase in inflation. Hereinafter, it is also envisaged that with increased wages, workers would consume more goods and services eventuating to put the economy in a virtuous cycle to lift it from recession.
In India, during this pandemic, RBI has acted responsibly and quickly to deploy a set of tools as a multidimensional strategy, which can be summarised in the following ways: one, repo rate cut from 5.15 percent to 4 percent and forward guidance to ease strains in the market. Two, asset purchase to address widespread dysfunction in the financial market. Three, regulatory easing by redefining asset classification to help banks declare NPAs. Four, liquidity provisioning and credit support to the primary and the health sector through TLTRO and LTRO operations. It was seen that as growth fell the RBI reduced the policy rate, with a conjecture that monetary policy actions will be felt with a lag of 3-4 quarters on inflation and 2-3 quarters on output; but to the surprise of many it did not transmit to the economy as expected.
According to data analysts, the pass-through of a policy rate cut to bank lending rates has been slow and incomplete. There has been a drop in the lending rates partially, but that drop is not even across the sectors. Unfortunately, the decrease in rate in the agriculture sector and the retail sector have been the least, for instance about 49 bps in farm lending rates. What is more, the data released by the central bank show that credit growth is largely driven by the agriculture and retail sector where policy transmission is quite muted. Also that the non-food credit growth stood at 6.7 percent in August 2021 as compared to9.8 percent in August 2019. This is when, RBI is maintaining a repo rate of 4 percent and a reverse repo at 3.35 percent since 22 May 2020, and when, a very high level of liquidity has set reverse repo rate as an operative rate for the market.
The country’s retail price inflation rate softened to 4.35 percent y-o-y in September 2021, from 7.34 percent in September 2020, even though there is a price rise in various commodities, such as metals, sugar, and other soft commodities, due to exogenous factors, the inflation is well within the RBI’s 2-6 target range. There has been a rise in inflation during the last five quarters but felt in some sectors only, depicts that this may not be due to policy transfer but due to other factors such as supply-side issues and logistic constraints.
These findings have led to a question that do monetary policy transmits its impact in a certain time framework? The obvious answer is ‘not always, it takes time for the impact to be felt in the economy. Many indigenous and exogenous factors affect its capability of producing desired results. India is a heavy importer of crude oil, which amounted to 27 percent of her import bill in FY 20. An unusual rise in the price of crude oil, to a level of as high as $80-85 per barrel, has a substantial influence on the price of goods and services. Another example is the monsoon that affects the inflation of food items dearly. A bad monsoon can drive productivity downwards resulting in less production of food grains and oilseeds.
The impact of a policy rate cut and other measures should have been felt fully in the economy by now as it is more than 4-5 quarters from the last rate cut, but unfortunately, it did not turn out so. An apparent co-relationship of the policy rate cut with inflation is missing. The growth trajectory data released by the Fed shows that GDP loss during the last two years cannot be fully compensated by added growth in successive years. Also, that partial compensation will take five to six years. Thus, it reveals that the monetary policy could not able to impart enough resilience to the economy to lift it from recessionary clutches.
This has raised many doubts about the monetary policy, whether the transmission channels of monetary policy are impaired; whether the policy, in general, is less effective during such crises; whether the financial markets are not capable of transmitting policy to the economy effectively; or whether we need an alternate tool to align macro indicators during global crises especially of this recent kind. Despite all the above, for sufficient reasons, it is clear that policy could not fully able to get itself transmitted to the general economy effectively to keep it in a healthy condition.
