Monetary policy is dead!
Hi Vivek,
Read on to see why some argue that the monetary policy has run its course and things are only getting worse for the economy.
What is Monetary Policy?
Monetary policy is action with respect to the supply of money that the Central Bank of a country makes to ensure sufficient supply of money.
The primary objective of the monetary policy of a Central Bank (RBI) is to ensure price stability. It does this through controlling the supply of money through open market operations( buying and selling of bonds and currency) and by changing the interest rates thereby controlling the flow for capital. RBI has other objectives too as the Government’s Bank and as the regulator of Banking, but let’s set them aside and look at the monetary policy bit.
Expansionary monetary policy is when interest rates are low, there increasing demand for capital. A danger with a very low persistent interest rate is inflation. Thus the central banks adjust interest rates to maintain price stability (low inflation). Moderate inflation is good for the economy as it indicates good demand and a growing economy. Too high an inflation erodes earnings and the currency loses value. Too low inflation indicates the economy is growing slower than it can.
Fiscal Policy
Fiscal policy is the measures with the government with respect to spending. It is majorly driven by expenditure and tax receipts. The gap between the two can be approximated to the fiscal deficit. The government controls the tax rates. Higher the tax rate, they suck out money out of the system. If the expenditure is too high, i.e., if a government is spending too much, typically, it results in increased economic activity, thus giving more money in people’s hands. More money with people and if the supply of goods remains constant, it puts inflationary pressure on the economy. It is in times of this that the RBI steps in and increases interest rates. This decreases demand for credit, thus discourage spending, thus keeping inflation in check.
From above it can be seen that both of the policies complement each other in helping maintain the health of the economy. It can also be noted that the primary object of government is economic growth and that of the central bank is price stability. There is an inherent tension between their objectives and hence the need for operational autonomy of RBI.The crucial link between monetary and fiscal policies is inflation. Too high inflation typically suggests that the economy is growing faster than it can. It is then that the RBI steps in and increases interest rates to stabilise prices. I argue that this crucial role of Monetary policy has reached its limit to help the system and that it is losing relevance in helping the economy.
Non-transmission of interest rate cuts
My post draws immensely from this thread by Vivek Kaul.
The RBI has cut the repo rate by 135 bps to 5.15% this year alone. But the weighted average rate of lending on outstanding loans has remained stagnant while that of fresh loans has only come down by 10 bps till the end of June this year. So, these rate cuts have not translated to actually making credit being more accessible to the end customer.
But why is this? After all, banks have access to capital at a cheaper rate. And there are enough Bank's competing for customers and so there is enough competition between them to offer the best interest rates to the customer. But why did it not materialise to reduced interest rate??
A plausible explanation here is the falling household savings. When this falls, the banks have lesser money to give out loans. Hence the demand for credit grows. It is to be noted here that its the individuals and hence the small ticket loans whose demand will increase. But this demand is increasing in a section of society which is at a higher risk of default. Many economists have highlighted on the MUDRA and such schemes having a high risk of default. In fact, banks have already started reporting higher NPAs for these loans. And since the majority of them are unsecured loans the recovery of loans from such cases is slim. But this is diverging from the main topic here.
So, household saving is falling. This leaves little funds with a bank to give out loans whilst there is increasing demand for credit. Add to this the latest fiscal stimulating decisions to prime the economy, the fiscal deficit of the country has increased further. This leads to what is called the crowding-out effect. Crowding out effect is when the government is borrowing so much money from the market that there is little left to give out loans to others. This, in spite, of capital becoming cheaper due to falling repo rates. With little capital left for others after the government takes its share, there is a dearth of capital. So essentially the banks continue to depend on their own capital to give out loans and do not benefit from the repo rate reduction.
Ponzi like saving schemes
But if the government is investing this money into productive investments, it would still have a positive effect on the economy. Here lies the major part of the problem. Schemes like PPF, NPS, etc artificially offer higher interest than bank savings or fixed deposit accounts. The excessive borrowing by the government is going into servicing these interest obligations for the government. The banks cannot offer such high-interest rates and so lose out on such deposits, thus hurting the capital available with the banks to offer loans. Now their cost of capital is increased to the interest they offer on deposits. Given the government offers such high interest rates, the banks are left with no choice but to increase their interest rates too, in an effort to get more deposits. So the cost of capital for the bank continues to remain high because they cannot lower their savings rate of interest. Interestingly, only today the RBI urged the government to reduce the interest on these saving scheme to facilitate the transmission of reduced interest rates.
To sum it till here, cheap credit crowded out by the government to fund schemes which offer very high-interest rates renders monetary policy useless because the saving rate of interest rate given by the banks is high and so the cost of capital remains high for the bank. This creates a liquidity crunch with banks even when the rate at which they could have borrowed is at a record low.
The RBI knows this. Hence it has made it mandatory for bank's to link their retail and SME loans to an external benchmark like the repo to ensure transmission. This will further hurt the RoA for banks.
Stagflation
An ineffective monetary policy reminded me of stagflation. Stagflation is when economic growth is low (high unemployment) coupled with high inflation. Typically, as suggested by the Phillip curve, low inflation is seen when unemployment is high and vice versa. But Phillip's curve is violated during stagflation when the prices rise despite high unemployment and slow growth.
We know for a fact that unemployment is at a record high and GDP growth is at a record low. We are also seeing a spike in inflation in the recent past. This was the reason why even if the economic growth was at a historic low, the repo rate was not reduced in its review of interest rates last week. We may well be staring at a buildup of stagflation situation.
Stagflation normally happens when there is a sudden supply shock mostly causing a sudden price spike. With industrial utilisation at below 75%, supply shock may not be a reason for stagflation. What could be causing the problem is excess currency being printed by the reserve bank to fund the government's deficit. The excessive money printed is not going into efficient investments and hence is not creating jobs, but still with excess capital comes the risk of inflation. In fact, the former PM Singh suggested that we might be headed towards stagflation. In such a situation monetary policy is further rendered useless and careful coordination between the fiscal and monetary policies are needed to get the inflation- growth- employment equation back to stability.
All policies have unintended byproducts, it's important they are recognised and addressed before they become big.
Regards,
Bheem
Disclaimer: All the views expressed above belong solely to the author, and do not represent those of the organisation he works in.
The Duologue is an effort by Vivek and Bheem to have a dialogue about varying topics.
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