Central banks face uphill task in monetary policy formulation

Mumbai: Central banks, including RBI, are faced with many challenges to the current analytical background of monetary policy formulation, says a report by SBI economists.

The main challenge is intellectual challenge. Certain ingrained economic beliefs at the core of the prevailing analytical paradigms may have facilitated the loss of policy headroom and may complicate the quest to regain it to the extent that they influence policy. It would be worth re-examining these intellectual macroeconomic paradigms in order to see the world differently.

For the record, even though we do not expect any rate change in the upcoming monetary policy meeting, we expect liquidity stabilisation by the RBI, it says. Globally, the happenings post the global financial crisis (GFC) puts a serious question mark regarding the long-standing analytical paradigms on which global central banks base their policies.

There are primarily 3 scholastic challenges confronting monetary policy making in today's pandemic and post GFC. Interestingly, such challenges also now confront monetary policy making in India as we find out in the course of our research in this report. First, Milton Friedman's popular dictum "inflation is always and everywhere a monetary phenomenon" possibly might not pass the test of scrutiny in this post GFC and pandemic world. This idea is also ingrained in the real business cycle of New Keynesian models where it is assumed that nothing changes but for prices and the economy only returns to steady state after a disruption. Thus, monetary policy in theory is assumed to have no influence on real factors. In essence, this also clearly rules out the role of financial factors in economic fluctuations.

The reality is, however, far from this age-old dictum. For example, it is now a common belief that globalisation has acted as a powerful tool to allow central banks to keep interest rates low for significantly longer period of time. In essence, technological advances and globalization of labour markets have played significant role in contributing to extended period of low inflation with entry of low-paid workers in workforce at home and globally as emerging markets opened up.

In 2008, when GFC happened central banks significantly eased the stance and – since inflation did not appear again till most recently – persisted in such, thereby pushing interest rates down further. Most importantly, as interest rates declined, debt-to-GDP ratio has climbed up astronomically and the economy is thus more vulnerable to higher interest rates, which in turn makes it very difficult to raise them in future lest markets could disorient. In other words, low rates beget lower rates (Borio and Disyatat (2014). This is a big risk that even RBI is currently facing as low rates in the system are fuelling inadequate risk recognition with irrational pricing of credit risk.

Second, one of the important tools for understanding inflation behaviour is the Phillips curve, which presumes that inflation is partly driven by gap variables that measure how much economic activity deviates from its potential. Gap variables can include the percent deviation of real GDP from potential GDP, known as the output gap / domestic slack. Any central bank monetary policy statement, including that of the RBI always identifies gap variable as a significant determinant of inflation. This report particularly looks into this aspect.

"We thereby estimate the link between inflation or change in inflation and output gap in India over a period of 15 years (or 60 quarters), with the help of rolling regressions, where each regression covers a 5-year window of data," says Dr Soumya Kanti Ghosh, group chief economic advisor, SBI.

Ghosh said: "We have taken CPI (All-India) as the measure of inflation and estimates of the output gap are obtained by applying the Hodrick-Prescott (HP) filter." The study estimated two equations. The first equation involves 'change in the inflation rate over the previous quarter' on a constant term and the value of the output gap and the second equation uses 'actual inflation' in place of change in inflation.

The results indicate that in case of India the link between inflation change and output gap was never strong (the gap coefficient was under +0.40) and it has been declining. Meanwhile, the link between inflation level and output gap (equation 2) was strong (the gap coefficient was as high as 0.91 in absolute terms) during 2016 to 2018 but it is also weakening post 2018. The link is completely lost during the Covid period implying the irrelevance of output gap in explaining inflation in post Covid world even in India. The results do not change if we use core inflation in place of headline inflation.

Third, there is a growing recognition that financial factors, which we might have neglected for long, are also important. Arguably, this explains why the paradigm embodied in New Keynesian models had difficulties coming to terms with the GFC. In effect, by playing down the role of financial factors and overestimating the steady state, it could not identify the build-up of risks ahead of the crisis nor replicate its dynamic.