Why MPC member Jayanth Varma differs with RBI

IIM-Ahmedabad professor of finance Jayanth R Varma—one of the six members of the Reserve Bank of India's (RBI) monetary policy committee—despite voting in favour of retaining the repo at 4%, has expressed reservations on the RBI taking an accommodative monetary stance.

As per the minutes of the Monetary Policy Committee’s (MPC) meeting held from August 4 to 6, Varma was vocal about the increasing disconnect between the risk and reward of an accommodative monetary stance. “As the pandemic continues to mutate, it appears to me that the balance of risk and reward is gradually shifting, and this merits a hard look at the accommodative stance,” said Varma.

Below is a verbatim reproduction of Varma’s comments during the meeting:

First, Covid-19 is beginning to look more and more like tuberculosis which kills a very large number of people every year without inflicting major damage to the economy; in other words, it is beginning to resemble a neutron bomb. The ability of monetary policy to mitigate a human tragedy of this nature is very limited as compared to its ability to contain an economic crisis. Related to this is the lengthening of the time horizon of the pandemic. Global experience (particularly countries like Israel which are witnessing rising case counts despite very high levels of vaccination) suggests that vaccination is insufficient to stamp out the pandemic though it might reduce its severity. The possibility that Covid-19 will haunt us (though with lower mortality) for the next three to five years can no longer be ruled out. Keeping monetary policy highly accommodative for such a long horizon is very different from doing so for what was earlier expected to be a relatively short crisis.

Second, monetary policy has very broad effects on the entire economy, and this was appropriate in the early phase of the pandemic which caused generalized economic distress. More recently, however, the ill-effects of the pandemic have been concentrated in narrow pockets of the economy. At the industry level, contact intensive services have suffered heavily, while many other industries are now operating above pre-Covid levels. At the firm level, MSMEs have suffered severely, while large businesses have prospered. At the household level, the pandemic has been devastating for weaker sections of society, while the affluent have weathered it reasonably well. Geographically also, the pandemic has done its worst damage in around 100-200 districts spread across a relatively small number of states. Monetary policy is much less effective than fiscal policy for providing targeted relief to the worst affected segments of the economy. Indeed, monetary accommodation appears to be stimulating asset price inflation to a greater extent than it is mitigating the distress in the economy.

Third, inflationary pressures are beginning to show signs of greater persistence than anticipated earlier. There are indications that inflationary expectations may be becoming more widely entrenched. Most worrying of all, there is now a reduced degree of confidence that demand-side inflationary pressures would remain quiescent. After averaging above 6% in 2020-21, inflation is forecast to be well above 5% in 2021-22 and is not expected to drop below 5% even in the first quarter of 2022-23 according to RBI projections. While there is some comfort that inflation is forecast to be below the upper end of the tolerance band, it is important to emphasize that the inflation target for the MPC is 4% and not 6% or even 5%. The tolerance band is designed to allow for forecast errors, implementation shortfalls and measurement issues. Treating 5% as the target would significantly increase the risk of inflation targeting failures. (While I have seen some commentary suggesting that there may be a case for raising the inflation target during the pandemic, that decision clearly lies with the government and not with the MPC.)

In this context, I believe that the current level of the reverse repo rate is no longer appropriate. I am conscious of the fact that the MPC’s mandate is supposed to be restricted to the policy rate or the repo rate. Unfortunately, the monetary policy statement of this meeting (as in the past several meetings) contains the line: “Consequently, the reverse repo rate under the LAF remains unchanged at 3.35%”. I have—for some time now—arguing that if the reverse repo rate does not fall within the remit of the MPC, then the announcement of this rate should be in the Governor’s statement and not in the MPC’s statement, but this view has not found favour with the rest of the MPC. Hence, I have no choice but to express my disagreement with the level of the reverse repo rate. A gradual normalisation of the width of the corridor is warranted. In my view, a phased normalization of the corridor would increase the ability of the MPC to keep the repo rate at 4% for a longer period, and this should in my view be a greater priority for the MPC than maintaining an ultralow reverse repo rate for some more time.

At a time when the economic recovery is still nascent, monetary policy must serve as an anchor of macroeconomic stability. That would reduce the inflation risk premium as well as the term premium and help stabilize long term interest rates. As I have argued in my past statements, a low long term interest rate is more important for inducing investment-led growth than a low short-term rate. In this light, I fear that the forward guidance and monetary stance are becoming counterproductive. By creating the erroneous perception that the MPC is no longer concerned about inflation and is focused exclusively on growth, the MPC may be inadvertently aggravating the risk that inflationary expectations will be disanchored. In that scenario, rising risk premia could cause long term rates to rise. Easy money today could lead to high-interest rates tomorrow. On the other hand, by demonstrating its commitment to the inflation target with tangible action, the MPC will be able to anchor expectations, reduce risk premia, and sustain lower long term interest rates for longer thereby aiding the economic recovery. For these reasons, I am not in favour of the decision to keep the reverse repo rate at 3.35% and vote against the accommodative stance.

On the other hand, I vote for maintaining the repo rate at 4% for the following reasons. Economic growth was unsatisfactory long before the pandemic, and even if the economic ill effects of the pandemic abate to some extent, substantial monetary accommodation is warranted. Persistent high inflation means that the monetary accommodation has to be somewhat restrained, and, therefore, I argued above for raising money market rates towards the repo rate of 4% from the current ultra-low level of 3.35%. The repo rate of 4% corresponds to a negative real rate in the range 12 of 1-1.5% based on forward-looking inflation forecasts. In my view, this level of rates is currently appropriate for reviving economic growth without excessive risk of an inflationary spiral. The MPC needs to remain data-driven so that it can respond rapidly and adequately to any unforeseen shocks that may arise in future.