Author : Younes Ouaqasse

Expert Speak India Matters
Published on Aug 18, 2023
Inflation is proving hard to tame as central banks lose sight of their primary role of inflation-targeting
Central banks: Perils of losing focus The world over, for quite for some time, central banks have been facing criticism for not being able to control inflation. Their present unenviable position is largely their own doing. They followed an extra loose monetary policy after the COVID-19 pandemic declaration in March 2020. Then, when inflation started rearing its ugly head somewhere around the middle of 2021, they ignored it and waited far too long to act. As a result, even when they began raising interest rates, they were well behind the curve. By then, inflation expectations were rigidly set in. The inflation-targeting mandate by central banks gained prominence in the developed countries of the West during the 1970s. The remarkably high and persistent inflation during that period led the governments in those regions to recognise the importance of central banks prioritising price stability. It was also realised that, in order to effectively meet this objective, these institutions would have to operate independently and maintain a certain distance from the influence of politically-elected governments. This approach was adhered to and ultimately proved to be successful. In the two decades leading up to the 2008 financial crisis, inflation in the western countries averaged approximately 2 percent, a significant decrease from the 7-8 percent levels seen in the 1970s.
The world over, for quite for some time, central banks have been facing criticism for not being able to control inflation.
In the past, central banks in many emerging economies were often seen as extensions of their governments, with a primary focus on supporting government policies rather than on controlling inflation. However, over time, these jurisdictions have come to recognise the importance of price stability and the need for central banks to be independent from political interference. As a result, many emerging countries have adopted inflation targeting as the monetary policy framework for their central banks. Then came the 2008 global financial crisis, which was a major turning point for governments and central banks. The crisis was caused by a number of factors, including regulatory failures in the United States’ (US) financial sector, and it brought in a new set of priorities and challenges. Critical issues such as financial stability, systemic risk, and the need for intervention to rescue “too big to fail firms” were brought to the forefront. “Financial stability” is a term that is often used, but it does not have a single, universally agreed-upon definition. However, maintaining financial stability and mitigating systemic risk necessitate that governments, central banks, and other institutions take coordinated action. One of the unintended consequences of this coordination was that the central banks started behaving like arms of the governments; it led to the blurring of lines between the roles of governments and central banks.
It was also realised that, in order to effectively meet this objective, these institutions would have to operate independently and maintain a certain distance from the influence of politically-elected governments.
The roles of central banks have become increasingly blurred over time. They are now expected to address a wide range of economic and financial challenges, including tackling inequality, often intervening in financial markets (à la Green put), engaging in commercial operations and doing other odd jobs for the governments. In many of the jurisdictions, the central banks have been more than willing to accept these additional duties.

COVID-19 and the role of central banks 

The COVID-19 crisis was caused by a public health emergency that had a significant impact on the real economy, while the 2008 financial crisis was caused by a failure in the financial sector. As a result, the two crises required different policy responses. While a monetary stimulus was more relevant in tackling the 2008 financial sector crisis, it had its own constraints during the COVID-19 crisis. However, central banks largely followed the same approach to handling the COVID-19 crisis as they did during the 2008 financial crisis. This approach focused on using interest rates to stimulate the economy. Interest rates serve as a blunt tool for central banks. Many of the objectives that central banks seemingly aimed to accomplish through monetary policy amid the COVID-19 pandemic should have been more appropriately entrusted to their respective governments. Fiscal policy cannot be replaced by monetary policy. In this milieu, the central banks relegated their inflation controlling role, which was their main task—to be performed independently at an arm’s length from the government. All this, in some way, meant unlearning the lessons of the 1970s.
The central banks relegated their inflation controlling role, which was their main task—to be performed independently at an arm’s length from the government.
Central banks wasted quite some time from the middle of 2021 onwards in tacking the inflation problem. Initially, most of them were of the view that the inflation was transitory in nature requiring no regulatory intervention. Later, they argued that the inflation was on account of supply side disruptions, and the monetary policy wasn’t the right tool to address it with. It is anybody’s guess as to whether the central banks were acting as per their own beliefs and convictions or were guided by their governments.

Central bank course correction 

In the wake of increased criticism, and post the beginning of the Russia-Ukraine war in February 2022, the central banks suddenly woke up from their slumber. The aggressive interest rate raising cycle they followed thereafter was a desperate attempt to redeem their credibility. The US Fed has so far increased the interest rates by over 5 percent since beginning January 2022. Such a sharp rise in a short period is unprecedented in the US, perhaps with the exception of the early 1980s. In India, the Reserve Bank of India (RBI) started the repo rate raising process from May 2022 onwards. The rates were increased by 2.5 percent till February 2023, and have been maintained at that level since then. Of course, the situation in India and the Western countries have certain dis-similarities. While the central banks in the West aim at keeping inflation at 2 percent in those jurisdictions, they do not have any statutory mandate to do so. In India, the RBI has been mandated under law to keep the consumer price inflation in the range of 4+/- 2 percent. Just before the onset of COVID-19, many of the developed countries were, in fact, having too low an inflation, with their central banks struggling to raise inflation to 2 percent. In contrast, in India, the prospects of high inflation have invariably worried the government and the central bank, and have kept their top brass awake at night.
The aggressive interest rate raising cycle they followed thereafter was a desperate attempt to redeem their credibility.
The Indian government needs to be complimented for not going overboard in providing a fiscal stimulus post COVID-19. This is the main reason why India could handle the inflation demon in a relatively better manner as compared to many developed countries. However, we are nowhere near getting out of the woods—the July 2023 inflation numbers are testimony to that. The question that needs to be asked is, what was the objective of keeping the monetary policy extra loose for such a long period, and how did the actual outcome compare with the envisaged objective? Also, the consequences of the aggressive interest rate raising policy of the central banks, followed thereafter to tame inflation, need critical examination. For sure, at a broader level, the easy money policy during 2020 and 2021 resulted in reckless and speculative investment behaviour, created asset bubbles due to under-pricing of risks, and distorted financial markets. The P/E ratio of S&P 500, Dow Jones Industrial Average (DJI), BSE Sensex and BSE 500 became as high as 25.5, 23.3, 30.5 and 38.5 during these two years as against the 10-year averages of 15.8, 15.0, 17.4 and 15.6 respectively. The number of individual investors in the market increased exponentially. For instance, in India, the total number of demat accounts have now crossed 120 million; this number was 40.9 million on March 31, 2020. The trading volumes in the futures and options segment have gone over the top. The loose monetary policy increased the disconnect between the financial markets and economic fundamentals, and brought to the fore the negative distributional effects. Typically, wealthy individuals invest a substantial share of their savings in assets. They benefitted from the asset price appreciation. However, most individuals at the bottom of the wealth distribution have almost no assets and therefore weren’t so lucky. A K-shaped economic recovery was an obvious outcome. 
For sure, at a broader level, the easy money policy during 2020 and 2021 resulted in reckless and speculative investment behaviour, created asset bubbles due to under-pricing of risks, and distorted financial markets.
Loose monetary policy helped the big corporates in retiring their high-cost debts; consolidating their holdings by capital restructuring including through mergers and acquisitions and buy backs; repairing their balance sheets; and increasing their dominance and pricing power in the market. The low interest rates in 2020 and 2021 immensely helped the governments in their market borrowings at lower rates. However, the large quantum of government borrowings, needed to provide the fiscal stimulus, crowded out the private sector from raising debt. Also, low demand and poor capacity utilisation dis-incentivised any noticeable incremental investments and employment generation in the private sector. What about the small entrepreneurs? Some of the sectors that got targeted fiscal stimulus in terms of government subsidies and credit guarantees could have perhaps benefitted. It may be interesting to do an empirical study on this subject. The negative real returns from the bank deposits for a prolonged time period adversely impacted the pensioners with no inflation indexation of pensions and other people dependent of fixed income cash flows. Of course, the poor have been most impacted by the high inflation. Following the extra loose monetary policy era, the central banks’ thinking took a sudden U turn. The aggressive monetary policy tightening by the central banks, besides having an adverse impact on different stakeholders including the households facing EMI payments and the firms planning capacity additions, had financial stability implications. The failure of SVB and some other small banks in the US was as a result of this. Many institutions holding bond assets, with the regulatory requirement of marking them to the market in their balance sheets, were in a quandary—such a massive interest rate risk came as a shock to them. Forget about the commercial entities, it is doubtful whether even the central banks had planned for such a contingency.
The inflation has proven to be stubborn and sticky, and the central banks are unsure of the timelines by which they will be able to bring it to the desirable levels.
The end result of all this is that the global economy is in turmoil and faces unprecedented uncertainty. The inflation has proven to be stubborn and sticky, and the central banks are unsure of the timelines by which they will be able to bring it to the desirable levels. The central banks face loss of credibility, and doubts have been raised about their forecasting models and capabilities. The questions that arise are—was it worthwhile for the central banks to keep the monetary policy extra loose for such a long period in 2020 and 2021? Shouldn’t the central banks focus on their inflation targeting role and get relieved of their other duties, some of which may in fact be conflicting with this role? Does the government-central bank relationship needs a relook? While the answer to the first question appears to be in negative, the answer to the remaining two is certainly positive.
Ajay Tyagi is a Distinguished Fellow at the Observer Research Foundation
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