Monetary policy is either expansionary (mainly by lowering interest rates to combat a recession or a recessionary situation) or contractionary (raising interest rates to control inflation).
Interestingly, two different economies are following divergent monetary policies trying to solve their economic riddles—one is aiming to control high levels of inflation and the other is trying to move accelerate from “stall speed” (it currently stands on the precipice of economic recession) and an unacceptably high level of unemployment. The former is India; the latter is the U.S.
While the Reserve Bank of India (RBI) has been tightening the monetary screws (12 rate hikes in the past 18 months) more than ever before, the U.S. Fed is following ultra-expansionary monetary policy. However, success has been steadfastly eluding both. So, what gives?
Even at the cost of sounding clichéd, I am tempted to invoke a much abused phrase: “this time it’s different.” Past sins are clearly catching up now, rendering the monetary policy actions ineffective, when ordinarily they could have had an impact. To add to the woes, external factors are conspiring against success.
First let’s focus on India, where the average inflation since January 2010 is 9.6%.
Source: Office of Economic Advisor (GoI), RBI
The very fact that such a long tightening phase has failed to affect prices to the extent desired clearly indicates that inflation in India is mainly structural in nature (not cyclical). Years of neglect suffered by the agriculture sector are evident from the excessively low level of investment in the sector (Figure 2).
Figure 2: Gross Capital Formation (GCF)
Note: QE = quick estimate
Source: Economic survey, GoI
For a sector that supports about 65% of India’s population, there is a high price to be paid for such neglect. Not surprisingly, agriculture productivity levels in India are among the lowest in the world, as is evident from the yields shown in Figure 3.
Figure 3: Comparison of Yields (hectogram per hectare)
Hugely inadequate physical infrastructure in agriculture (be it irrigation, cold storage facility, transportation, etc.) not only leads to low levels of productivity, but also to a huge loss of foodgrain due to improper storage. In India, more than 10% of foodgrain production gets wasted every year. As per the report of the 11th Planning Commission, preventable post-harvest losses of foodgrains are estimated at about 20 million tonnes a year, which is nearly 10.5% of the total production. To put things in perspective, India wastes close to 50% of Australia’s annual foodgrain production. Even a bumper crop is a problem for India and the country has had to resort to exporting foodgrains this year to tide over the storage problem, while every day millions of Indians go to bed hungry.
Not surprisingly, food inflation has remained persistently high in India, which has started to feed into overall inflation (Figure 4).
Figure 4: WPI/Food Inflation (%, y/y)
Source: Office of Economic Advisor
Moreover, as I have said in previous posts, inflationary pressures are also coming from the trade channel, as a result of the persistently high prices of oil and other commodities. The problem has been further compounded by the recent depreciation of the rupee (Figure 5), mainly on account of a perceptible retreat of FX flows due to the decreasing appetite for emerging market risk assets, as the European sovereign debt crisis continues to boil.
Figure 5: USD/INR
This is leading to imports becoming even costlier (negating the effect of some of the recent softening in commodity prices), further adding to inflationary pressures and thereby rendering the RBI’s monetary policy efforts futile. All this, despite clear evidence of demand destruction in India.
At the other end of the monetary policy spectrum lies the U.S. Fed…
Figure 6: Fed Funds Rate
As the global crisis erupted, the Fed acted quickly and eased money policy as fast as it could (Figure 6). However, with the Fed Funds rate at as close to zero as possible (and having been so for a longish period of time), the Fed has no more policy bullets, except for continuing to keep rates low, which is what it is doing. Here again, an extended period of ultra-low interest rates has not ratcheted up the economy.
With house prices yet to bottom out and unemployment levels remaining stubbornly high, the excessively leveraged U.S. consumer seems to be thoroughly down and out. The Conference Board Consumer Confidence Index stagnated at a two-year low in September (Figure 7), indicating that consumers are deeply worried about the state of the economy, and hence about their income and employment situations.
Figure 7: Conference Board Consumer Confidence Index
With consumers retreating and the crisis of confidence becoming all pervasive, the low interest rate regime has simply failed to spur the economy. The policy limitation that close-to-zero interest rates entailed forced the Fed to go for QE. Unfortunately, even this did not help much. Credit growth did not perk up materially and all that QE resulted in was rising excess reserves (rather than further lending), as credit-worthy borrowers refrained from borrowing and lending institutions also preferred to hold tight (Figure 8), given the crisis of confidence and the fear of tighter regulations.
Figure 8: Bank Credit (%, SAAR)
Source: St. Louis Fed
With corporate profits moving to record-high levels, most companies, especially the nonfinancial ones, have preferred to use their cash to deleverage. The same has gone for credit-worthy consumers. Even the tax breaks and transfers have been, to a great extent, used to reduce debt. They have helped to arrest the slide in consumer spending, but have not stimulated an increase. Even the vast sum of money used for the “cash for clunkers” scheme or the “second home buying scheme” helped the economy to perk up only in the short term and the positive multiplier effect soon faded away. Of course, it did not help that Europe was hurtling faster and deeper into trouble.
The fact also remains that both the RBI and the Fed have not necessarily always taken the right decisions (though these been debated enough in the public domain and are beyond the scope of this article). Moreover, the politicians of both countries have played an important role in spoiling the party—in the U.S. through one-upmanship, and in India through sheer inertia (policy paralysis for some). This reminds me of what Charles Dickens wrote in “A Tale of Two Cities” (“it was the age of wisdom, it was the age of foolishness”), though in a slightly altered form: When the world needed wisdom, foolishness was more readily on display.