Measuring the strength and resilience of demand recovery from the depths of the pandemic is a challenge for central banks around the world. Even those with single data on unemployment that allow for multidimensional insights are vulnerable to uncertainty due to distortions caused by the epidemic, uncertainty about its reach, and anxiety about unknown distortions. Most worry about being on the side of caution, preventing the policy from being modified in line with evolving refunds; Others with less ability are forced to lack choice. Unlike markets and analysts who tend to be more confident, central banks are more persuasive to wait, watch and ensure that early bounces won’t dissipate.
Understanding macroeconomic conditions is made more difficult by sudden shortages, bottlenecks, supply chain collapses, unstable new formations, geopolitical hurdles, and jumps in energy and other prices; These rioters raise concerns about more to come. Informed guesses about the liquidation of display issues are speculation at best. As a result, no central bank is able to assess demand with sufficient confidence, which is usually possible for monetary policy in normal bullish periods.
In light of this, Indian monetary policy is likely to be at an inflection point more than is evident since the start of the liquidity normalization announced by the Reserve Bank of India on Oct 8. Monetary terms (bit.ly/2XpIVar). However, the expected pressures did not materialize, raising doubts if the demand was properly assessed. In fact, the pendulum swung to the other side – either demand was too low or the production gap was bigger than previously thought (bit.ly/2Z1iGrX).
This development, which reflects similar challenges elsewhere, is now in a critical position: lies against the background of the gradual normalization of excess liquidity in the specific demand situation.
In its policy review, the RBI clarified that discontinuing GSAP does not imply a sharp drop in liquidity and ensures gradual, undisturbed rafting to the “visible shore”. The central bank also maintained its accommodative stance for as long as necessary to revive and maintain growth on a permanent basis and mitigate the impact of Covid-19 on the economy, while ensuring that inflation remains within the future target.
There is a notable separation made by the Reserve Bank of India between the repatriation of excess liquidity and standard monetary policy or interest rate changes. Some might align themselves with the US Federal Reserve, which has successfully decoupled the decline in asset purchases from interest rate increases, with the latter staying far away at this point. The similarity is irrelevant to the discourse of politics, but the distinction is not. Central to this is the size of the output gap and the various assessments of the Reserve Bank of India, market assessments and analysts. If there was a struggle between the two over inflation readings not too long ago, now it is about the demand gap and how quickly it closes.
Markets and most analysts believe that the production gap is closing too quickly, beyond the expected speed; Therefore, inflation risks cannot be ignored and the Reserve Bank of India will fall behind the curve if it does not start to normalize monetary policy along with liquidity, which still has a long way to go given the size of the surplus. Most believe that the policy rate should be raised sooner than is currently reported by the RBI; Otherwise, the rapidly recovering demand could cross the gap. In other words, normalization of liquidity alone is not sufficient to dispel inflationary risks.
These beliefs are clearly inconsistent with the view of the central bank, which sent it and acted upon it by decoupling excess liquidity from interest rate adjustments. The RBI attempts to remove the effect of excess liquidity on interest rates by normalizing the former without any change in the policy rate. But markets are driven by demand optimism. Therefore, expectations of their “policy” can push interest rates higher than what the central bank would like or is comfortable with.
Is the Reserve Bank of India right, or are the markets as well? There is a contradiction on the part of the central bank: the 9.5% GDP growth forecast is unchanged with a sharp 40 basis point drop in annual inflation expectations, but the actions indicate that it is either unsure or not completely convinced that the recovery is securely rooted after the pandemic exit. When asked about this disparity in the post-policy call, the Governor of the Reserve Bank of India indicated that there was a disparity; He said growth was not close to desired levels, stagnation or production gap persisted, and the Reserve Bank of India was looking for signs of its resilience and solidification. In an earlier speech, Deputy Governor Batra stated that the production gap was larger this year than the previous one.
The output gap is highly subjective; The potential output, from which it is derived, is not directly observed. The RBI did not specify this exactly. Analysts have their own estimates of potential production. Therefore, the interpretation of the output gap becomes very important at this point, especially in times like coming out of the respite caused by the pandemic, and even more so in countries like India that do not have accurate or timely data on unemployment. It is logically possible to say at the same time that four-fifths of the labor force in India is employed in the informal sector and we know nothing of its condition!
So, the Reserve Bank of India has a difficult task at hand – try to persuade the markets and bring them to their assessment of the output gap. It needs better clarification than in the manifesto and post-policy conference. Otherwise, broad demand optimism could prematurely overshadow the impact of liquidity withdrawals on interest rates and prevent the central bank from remaining accommodative for as long as it deems necessary.
The idea of pursuing growth optimism everywhere leads to enthusiastic market expectations about the strength of the recovery. And it has repercussions in creating conflict for the central bank, which cannot easily afford its 9.5% real GDP forecast while at the same time saying that growth is too fragile and requires support. Or the output gap is too large. The settlement of this conflict is the turning point in monetary policy. Not an easy task by any means. Ask any central bank.
Macroeconomics expert based in New Delhi