Monetary policy should look beyond inflation

Last week this column stated that our monetary, liquidity and intervention policy all have a bearing on our external sector stability.

Our current monetary policy framework aims for macroeconomic stability by focusing on CPI. The basic axiom is that higher interest rates reduces aggregate demand, and therefore controls inflation.

Does this axiom work in India? In 2014, in the US, about 77% of US bank loans were to retail consumers. Higher interest rates would indeed reduce consumer demand there. In India, at the same time, only 18% of bank loans were to retail consumers, and the remaining 82% was to producers, intermediaries, and towards investments. While most developed nations are "borrow-and-spend" economies, India is a "borrow-to-produce" economy. Other things being equal, can higher interest rates in India end up fuelling additional inflation via higher input costs?

Higher interest rates could still control inflation in India, under the right external context. If we have persistent high current account and fiscal deficits, and therefore the prospect of a sharply weaker rupee, higher interest rates could attract foreign inflows, and stem currency outflows. This could the help stave off future currency-led inflation, even if CPI was manageable at that point in time.

In short, monetary policy must look at overall financial stability – across inflation, employment, and external sector stability.

The one area that can best help us in all this today is fresh infrastructure investments – into irrigation & water management, roads, railways, education, low-cost housing, power, ports. Such investments will address supply side issues around food, and reduce inflation. They will create jobs, both in their setting up, and later, in the economic activity that they spawn. They would strengthen our external sector by improving domestic production, both through Make in India and Make for India.

The experience of the last ten years has made infrastructure investments a bad word. However, we have no choice but to learn from the past challenges and move on. Of course, execution and government policy have the biggest role to play here. But we also need help from a broader financial framework to foster an investment cycle – including channelling some of the new found liquidity into productive investments, rather than into MSS alone.

In summary, believe a financial stability monetary approach should be cognisant of employment alongside inflation, address external sector vulnerabilities, including unhedged currency exposures, and focus on a wide range of market metrics and tools.