Home / Opinion / Columns /  Let’s talk about the downside of ultra-dovish policy

Interest rates have been on their way up across the world. In this environment, many economists, analysts and fund managers have raised doubts about the effectiveness of monetary policy in controlling inflation. A similar enthusiasm in questioning its effectiveness was missing when interest rates were on their way down after the covid pandemic struck in early 2020. Given that monetary policy is hardly a science, this lack of balance is surprising.

The world is currently facing the ill-effects of the dovish monetary policies run by central banks since early 2020. Crypto bubbles continue to implode. And so do real-estate bubbles all across the world. In all this, stock markets have largely held on.

The low-interest-rate environment that prevailed after the covid outbreak changed the incentives that affect how people go about investing their savings. Let’s look at this in the Indian context. Data from the Reserve Bank of India (RBI) tells us that nearly two-fifths of the incremental financial savings in 2020-21 were invested in fixed deposits.

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In 2021-22, the incremental proportion invested in deposits fell to a little over 27%. This was primarily because interest rates on fixed deposits fell. In 2019-20, the weighted average interest rate on fixed deposits was 6.38%. In 2021-22, it had fallen to 5.03%.

This incentivized people to look at other modes of investing by taking on higher risk than they normally would. In 2020-21, of the total proportion of the incremental financial savings, only 2% went into mutual funds. Another 1.2% went into buying stocks directly. In 2021-22, these shot up to 6.3% and 1.9%, respectively.

This tells us that people bought more stocks (both directly and indirectly) in search of higher returns. It is also worth remembering that stock prices peaked around October 2021. Hence, a significant amount of money invested in stocks was invested slightly before, around and after the time stock prices peaked. This, as anyone who understands the basics of investing will tell you, is not the best way to go about it.

Hence, the short-to-medium term risk when it comes to household balance sheets has gone up. This hasn’t mattered until now, given that stock prices have remained strong. But even with that, this isn’t necessarily a good thing for the economy as a whole.

There were other changes in the way people have invested. In 2020-21, around 8.9% of the incremental savings had been invested in small savings schemes (excluding the public provident fund or PPF). This shot up to 13.3% in 2021-22. Further, in 2020-21, 17.3% of the financial savings were invested in pension and provident funds (including PPF). This jumped to 22.7% in 2021-22.

The explanation for this is simple. The rate of interest on offer on various government provident funds, the PPF and small savings schemes was and is higher than on fixed deposits. In 2021-22, the interest rate on PPF was 7.1% as against the 5.03% an investor got from fixed deposits. The Senior Citizens Savings Scheme and Sukanya Samriddhi Scheme offered an even higher 7.4% and 7.6%, respectively. This incentivized people to invest in such schemes.

What’s the implication? Typically, when an investment manager runs an investment scheme, the money raised is invested in certain financial assets. The returns they generate, net of fee and expenses, are shared with the investors.

Small savings schemes aren’t run like that. The fresh money coming into these schemes in any given year is used to redeem investments that mature that year. What remains goes directly into the central government’s budget and is used to finance the fiscal deficit.

What this means is that the money that has been invested in small savings schemes post-covid will have to be redeemed in the years to come. Given that redemptions are done through fresh money, the government needs to ensure that more and more money keeps coming into small savings schemes in the years to come. The only way to ensure this is to offer a higher rate of interest than fixed deposits.

This only increases the pyramid nature of these government-backed schemes. Further, in an environment of dovish monetary policy, it limits the ability of banks to reduce interest rates by as much as RBI would like them to.

At the same time, higher savings through the provident funds (other than public provident funds) also implies higher government payouts in the years to come. In that sense, the liabilities of the government go up.

This is not to say that central banks shouldn’t have cut interest rates when covid struck. Not at all. But they should have tried to communicate the unintended consequences arising from an ultra-dovish monetary policy. Take the case of the US Federal Reserve. It barely talked about the real-estate bubble it helped blow after early 2020 while it was inflating. But now with the bubble deflating, the Fed is all over the place trying to take credit for it.

The same stands true for many economists, analysts and fund managers who’ve become cheerleaders for central banks cutting and maintaining very low interest rates, without talking about the risks involved. It’s important to talk about the overall consequences of economic actions and not just benefits.

Vivek Kaul is the author of ‘Bad Money’.

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