Expansionary monetary policy may be bad in long run

The Reserve Bank of India (RBI) monetary policy that comes after the Union Budget is always interesting to watch. Interesting, because the Governor has to do a lot of balancing act in post-Budget policies to ensure loose ends, if any, of fiscal policy, are tied up properly through the monetary policy.

The Fiscal policy essentially means the actions of government-related mainly to taxation and expenditures. Monetary policy aims at using all the tools in the hands of central banks to manage money supply in order to create growth and manage inflation, employment etc. The textbook economics says that in normal circumstances when the economy is growing well, there is no severe recession and inflation is under check if one is expansionary, the other has to compliment it by being somewhat contractionary. But, the monetary policy delivered last week soon after the Union Budget took everyone by surprise.

The Interim Budget presented on February 1 announced fiscal slippage for the second consecutive year, unveiled a massive spending programme to arrest rural distress, gave a huge tax cut to the middle class and opted for an enormous borrowing programme – a perfect recipe for inflation to build up in the foreseeable future and a rise in inflationary expectations of the households. The government, which was shortly plunging into national elections, was only expected to throw all the rule books out of the window, open its purse strings wider than ever and do whatever to boost to consumption.

The governments come with a short tenure of five years and therefore their horizon is also confined to that. No surprise, the centre announced the opening of floodgates of benefits to all sections who mattered in the upcoming polls.

Surprising move

But what surprised almost all stakeholders was the action of newly appointed Governor of RBI Shaktikanta Das. Instead of choosing a tight leash on money supply, he unleashed money in the market instantly making everyone from the government to the market and consumers happy.

He unexpectedly lowered its repo rate by 25 bps, while shifting to a neutral policy stance from one of calibrated tightening. His actions immediately restored the bond market confidence in the RBI Governor because his rate cut action also came with a bleak warning on future inflation trajectory. The yields on government bonds fell as the bond market felt their fear over future inflation was unfounded.

After all, someone sitting at the helm with all control of money was so optimistic that he did not mention fiscal slippage in the policy and his inflation forecast was more benign than even a novice, who could see it looming large. The governor complimented the government with a security-free loan of Rs 1.60 lakh to a farmer. It suddenly started raining money for the countryside both from the government and the RBI as if there was no tomorrow. Economists started saying that growth is back on the RBI’s mind and inflation has been relegated to a secondary place.

To make the records straight, inflation is not under control on all counts. A lowered food inflation may have helped the headline look better but Core inflation, which is called non-food, non-fuel, is still high at about 5.5%.

RBI very well took that into account barring this one time when Das chose to make an only passing reference to it. For him, the volatile oil prices were also not as great a concern because the policy statement had only some vague reference to it. But a survey of household inflation expectation in the next one year, which came soon after the policy announcement, clearly said that a fairly large number of people expected inflation to rise in the course of the year.

Tepid credit growth

Now, coming back to borrowing, the 25 basis point cut may prompt banks to ease their lending rates but what about the credit offtake by businesses in the months ahead of election?

A third of banks’ gross credit is lifted by the industry, whose credit growth is so tepid that it grew below 5% last month. This means private investment is sluggish and uncertainty around elections is expected to keep it low. Businesses do not invest in an environment of uncertainty. So, most of the loans after rate reduction will go to the retail sector and private consumption will rise, which if not properly backed by investment, will raise inflation in the coming months. It is no brainer.

However, some critics tried to reason out the RBI’s action saying that central banks across the world work in tandem with the governments and not against. They even cited the extreme case of the then US Federal Reserve Chairman Ben Bernanke’s much talked “helicopter money”.

Well, when Bernanke first talked of ‘helicopter money’ borrowing the phrase from Milton Friedman, which essentially means printing more money and dropping it from helicopters for people to use, he was doing so to arrest a potential recession in the US economy. It did not happen though.

Years later, faced with a similar situation, Japan flirted with the same idea for some time and of late the European Union appeared to. The urgency for them to toy with an unconventional idea of an ultra-expansionary monetary policy was that they were nearly hitting a situation where demand was abysmally low and the central banks needed to generate higher spending to perk up production as well as consumption.

Again, the textbook prescription is that simultaneous expansionary monetary and fiscal policies are used in extreme circumstances when the economy of a country is pushed to a state where it cannot lift itself without a massive hand holding.

In the Indian context, however, none of the above is true. India is nowhere near a recession, there is no deflationary pressure on the economy. The demand has not hit rock bottom where producers stop production. Comparing the RBI’s open-heartedness to that extreme situation and making a similarity and therefore justifying it whether or not augurs well, only time will tell. Most analysts are of the view that when the inflation is a scare going forward and there is hidden unemployment, RBI should have put some restraint at the moment.