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Overreaction in Indian Monetary Policy

Article  in  Economic and political weekly · March 2019

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Ashima Goyal Abhishek Kumar

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COMMENTARY
Overreaction in Indian
Monetary Policy
Ashima Goyal, Abhishek Kumar
A significant decline in trend
growth rate had led to a
debate in India that the central
bank’s monetary policy in its
exuberance for inflation control
is stifling growth. Though the
rise and fall of inflation in the
aftermath of the global financial
crisis has closely followed the
supply shocks, milder monetary
policy tightening is required for
moderating the negative effects of
these shocks.
Ashima Goyal (ashima@igidr.ac.in) and
Abhishek Kumar (abhishekk@igidr.ac.in)
are with the Indira Gandhi Institute of
Development Research, Mumbai.
12
post the global financial crisis laxity. The
RBI has been criticised for more than
necessary post-crisis stimulus and late
response to inflation.
While a significant decline in trend
growth rate had led to a debate in India
about the role of monetary policy in sti-
fling growth, a related debate is regard-
B
efore the onset of the global ing the rise and fall in inflation. Policy
financial crisis, the Indian econo- rates were raised primarily because of
my was growing at more than high inflation, despite their growth-
9%. There were signs of inflationary stifling effects. It can be argued that un-
pressure but it was largely presumed to controlled high inflation would have af-
be the result of high growth rate and fected growth even more severely. But
high world food inflation. As the crisis were these high rates actually able to
unfolded, both monetary and fiscal autho- control inflation?
rities responded quickly to maintain the
growth momentum. Between August Background and Methodology
2008 and April 2009, the policy repo The existing literature exploring the
rate was reduced from 9% to 4.75%, and drivers of inflation in India attributes
the 15 to 91 days’ treasury bill rate the rise in inflation either to the sus-
followed that cut. There was a quick tained surplus liquidity in the system af-
growth recovery, following macroeco- ter the financial crisis, that is, bad policy
nomic stimulus. In the very beginning of (Subbarao 2013), or to the increases in
the crisis, crude oil prices crashed but the minimum support price (MSP) of
soon started increasing. Inflation fol- foodgrains following international rise
lowed crude oil prices and food inflation in food prices, that is, bad luck (Bhalla
that had remained high. 2015). But inflation in India had been ris-
The Reserve Bank of India (RBI) start- ing before the financial crisis.
ed interest rate tightening to counter in- On the other hand, existing studies,
flation in 2010. But, from 2011 onwards such as Chinoy et al (2016) suggest that
growth rates started declining substan- the fall in inflation followed a combina-
tially as multiple shocks occurred, in- tion of the rationalisation of the MSP, ex-
cluding a fall in export growth due to ternal factors such as lower crude oil
the European debt crisis. Whereas the prices, and the monetary policy, which
interest rates continued to increase and moderated inflation expectations. So,
the trend growth kept sliding down (Fig- there was both good luck and contri-
ure 1). The repo rate peaked at 8.5% in bution from good policies in controlling
October 2011. A slight decrease in 2012 inflation. However, the literature, in
was quickly reversed from mid-2013 as general, suggests that more than a re-
part of the interest rate defence following duction in the aggregate demand (AD),
the United States (US)-led
Figure 1: Quarterly Trend Inflation and Growth
taper-on crisis. India was 2.4
also moving towards a
2.2
flexible inflation target-
2
ing (FIT) regime and for-
1.8
mally adopted it as the
In %
Growth
1.6
nominal anchor of mone-
tary policy in 2016. Al- 1.4 Inflation
though inflation targeting 1.2
was supposed to be flexi- 1
ble, it was implemented 1998 2000 2002 2004 2006 2008 2010 2012 2014
rather stringently, debat- Obtained from quarterly inflation and gross domestic product using Hodrick–
Prescott filter with λ=1600. Creation of a continuous gross domestic product
ably as an overreaction series is explained in Goyal and Kumar (2017).
MARCH 23, 2019 vol lIV no 12 EPW Economic & Political Weekly
 COMMENTARY

it was commodity prices and moderat-
ing of inflation expectations that had re-
duced inflation.
The current article, based on our pre-
vious work (Goyal and Kumar 2017,
2018), provides significant insight into
this ongoing debate. The study uses an
estimated dynamic stochastic general
equilibrium (DSGE) model to exploit the
variation in output, inflation and interest
rate series over time in order to estimate
a New Keynesian model for the Indian
economy, as used by Ireland (2011) for
the economy of the US. Features such as
marginal cost shocks arising from inter-
mediate goods, inclusion of habit persis-
tence and backward-looking behaviour,
strong monetary transmission comes shows signs of overshooting and then
from large interest rate changes. Reduc- undershooting (turning negative). More
ing the variance of the interest rate smoothing could moderate this. Since
shock can significantly moderate the the estimated persistence of the supply
large output cost especially if supply-side shock is low, there is no need to over-
action reduces cost-shocks. react to it. Although supply shocks play a
In any case, overreaction can be muted. very important role in the Indian econo-
The interest rate response to a cost shock my, milder monetary policy tightening
Figure 2: Impulse Response of Variables to Shocks in India and the US
Preference Cost Push Technology Monetary
1 0 1 0
-0.2
Output
0.5 -0.2 0.5
-0.4
0 -0.4 0 -0.6
0 10 20 0 10 20 0 10 20 0 10 20
2 4 0 0
1 2 -1
Inflation

make the model relevant for an emerg- -0.5

0 0 -2
ing market, while allowing comparison
of estimated parameters and impulse re- -1 -2 -1 -3
0 10 20 0 10 20 0 10 20 0 10 20
sponses with those for the US economy
1.5 0.4 0.1 1
as obtained by Ireland (2011).
Interest rate

1 0.2 0.5
0
Results and Discussion 0.5 0 0
The impulse responses from the estimat- 0 -0.2 -0.1 -0.5
ed model suggest a stronger monetary 0 10 20 0 10 20 0 10 20 0 10 20

transmission in India to output, inflation 1 0.2 0.6 0.2

and the interest rate, even in compari-
Output Gap

0.5 0 0.4 0
son to the US economy. This is contrary 0 -0.2 0.2 -0.2
to the belief that monetary transmission
-0.5 -0.4 0 -0.4
in India is weak and therefore interest 0 10 20 0 10 20 0 10 20 0 10 20
rate defence of inflation has a low output Quarter Quarter Quarter Quarter

cost (Mishra, Montiel and Spilimbergo Solid line is for the US and dotted line for India.

2012). Figure 2 gives the response of four Figure 3: Estimated Aggregate Demand and Supply
macro variables (on the horizontal axes) December 2008 December 2009
to the four model shocks—preference, 0.04 AD 0.04
AS AS
cost push, technology and interest rate. 0.02 AD
0.02
Counterfactual simulations show that SS SS
0 0
higher interest rates significantly affect- 0 0.01 0,02 0.03 0.04 0.05 0 0.01 0,02 0.03 0.04 0.05
ed growth during the period. Among the December 2010 December 2011
four model shocks, cost push (or supply 0.04 AS 0.04 AD
AS
shock) closely tracks the movement in 0.02
AD
0.02
inflation. Cost push remained a primi- SS SS
0 0
tive cause for inflation, since changes
Inflation

0 0.01 0,02 0.03 0.04 0.05 0 0.01 0,02 0.03 0.04 0.05
made during sensitivity analysis moder- December 2012 December 2013
ated the impact on inflation of the other 0.04 AD 0.04 AD
AS AS
three shocks. More volatile mark-ups im- 0.02 0.02
ply supply-side factors are important for SS SS
0 0
Indian inflation. 0 0.01 0,02 0.03 0.04 0.05 0 0.01 0,02 0.03 0.04 0.05
A lower impact of technology shocks December 2014 December 2015
on output but higher on inflation, 0.04 AD 0.04 AD
AS AS
compared to the US, implies an inade- 0.02 0.02 SS
SS
quate adjustment of actual to potential 0 0
output lowered output and increased 0 0.01 0,02 0.03 0.04 0.05 0 0.01 0,02 0.03 0.04 0.05
costs. This also reduced the contribu- Growth Growth

tion of technology to growth. The AS is aggregate supply, AD is aggregate demand and SS gives steady state inflation and growth.

Economic & Political Weekly EPW MARCH 23, 2019 vol lIV no 12 13
COMMENTARY
Figure 4: Hodrick–Prescott Filter Trend in Treasury Bills Rate and Crude Oil Price
8
7.5
In %
7 60
6.5
6 Treasury bills rate
5.5
1998 2000 2002
Obtained from annual 15–91 days treasury bills rate and Brent crude oil price using Hodrick–Prescott filter with λ=1600.
Source: RBI and Quandl.
in response to such shocks can moderate
the negative effects of the supply shock.
The asymmetric excess volatility in
India compared to the US that is due to
preference and technology shocks is re-
duced on introducing regime switching
between multiple steady states (SSs). In a
low growth regime, the aggregate sup-
ply (AS) schedule shifts to the left and
becomes steeper, thus creating persis-
tent effects from an initial shock. The
estimated model including multiple re-
gimes is used to obtain AD and AS sched-
ules, which incorporate the policy reac-
tion function, and to identify their shifts
during the Indian slowdown. The corre-
lation between the factors shifting AD
and AS was estimated to be negative,
which aggravates shocks. The post-2011
slowdown is explained by severe de-
mand contraction in response to adverse
supply shocks that affected steady-states
and therefore had persistent growth as
well as level effects.
Figure 3 (p 13) shows the shifts in AD
and AS after the global financial crisis.
At the end of 2009 interest rates were
lower and oil prices were higher in com-
parison to their values in December
2008. Negative supply shocks shifted the
supply curve leftward and positive de-
mand shocks shifted the demand curve
to the right by the end of 2009 in com-
parison to the end of 2008. These per-
sisted to the end of 2010 keeping the de-
mand curve to the right. The RBI’s mon-
etary stimulus was able to shift AD to the
right, and was strong enough to keep it
there for long. But commodity price
shocks kept inflation high. As the RBI
started increasing interest rates, the de-
mand curve shifted to the left. By the
end of 2011 it had reached the SS posi-
tion, and then fell below it as interest
rates continued to rise. Small interest
rate cuts between April 2012 and May
2013 were not able to shift the demand
14
View publication stats
100
80
In $ per Barrell
40
20
2004 2006 2008 2010 2012 2014
curve to the right. It was still left of the
SS when the next round of interest rate
tightening started in mid-2013 and shift-
ed the demand curve further left, deep-
ening the slowdown. As oil prices start-
ed falling in 2014, supply shifted to the
right and only by December 2015 was
the cut in interest rates sufficient for AD
to become expansionary.
It is evident that the monetary re-
sponse in the aftermath of the crisis was
disproportionate. There was overreac-
tion first in one direction and then in the
other. Also, monetary policy was too
tight for a longer period of time in pres-
ence of an adverse supply and terms of
trade shock. Not only that, even when
oil prices started falling and inflation
started decreasing, interest rates were
either not decreased or decreased less
than required. Trend oil prices and trend
interest rate diverged (Figure 4).
Conclusions
The findings suggest that the AD chan-
nel is not weak in India (Goyal 2018).
Higher rates had a significant output
cost. Supply-side factors, however, re-
main more important for inflation in
contrast with advanced economies
where inflation, in general, results from
a demand shock. However, the rise and
fall of inflation in the aftermath of the
financial crisis has closely followed the
supply shocks. With an AD channel,
An author-title index for EPW has been prepared for the years from 1968 to 2012. The PDFs of the
Index have been uploaded, year-wise, on the EPW website. Visitors can download the Index for
all the years from the site. (The Index for a few years is yet to be prepared and will be uploaded
when ready.)
EPW would like to acknowledge the help of the staff of the library of the Indira Gandhi Institute
of Development Research, Mumbai, in preparing the index under a project supported by the
RD Tata Trust.
Crude oil price
1998 2000 2002 2004 2006 2008 2010 2012 2014
which is stronger than expected, and in-
flation originating from the supply
shocks, there is a significant challenge
for the newly instituted inflation target-
ing regime.
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EPW Index
MARCH 23, 2019 vol lIV no 12 EPW Economic & Political Weekly