Home >Opinion >Columns >Opinion | The slowdown puzzle and RBI’s bias for policy action

What should be the role of monetary policy in spurring growth when faced with a slowdown of the type that India is witnessing? The Reserve Bank of India (RBI) seems to be following spiritual author Eckhart Tolle’s maxim: “Any action is better than no action, especially if you have been stuck in an unhappy situation for a long time." This is evident from the aggressive monetary easing that it has undertaken in 2019 so far, bringing down the policy repo rate by 110 basis points to 5.4%.

The use of such a counter-cyclical monetary policy is crucially dependent on the diagnosis of the nature of the current slowdown. Economic slumps may be transitory soft patches that can be ignored, or caused by cyclical or structural factors. Cyclical downswings may warrant counter-cyclical monetary action. However, where the slowdown is structural, deep-seated structural reforms would be the need of the hour. RBI, in its recently released annual report, has concluded that “the recent deceleration could be in the nature of a soft patch mutating into a cyclical downswing, rather than a deep structural slowdown". This would justify further monetary easing this year.

The problem with such monetary easing is two-fold. One, how appropriate, in the first place, is monetary policy as a response to the slowdown, especially if it is cyclical? Two, how sure are we that this slowdown is cyclical and not structural?

Regarding the appropriateness of monetary policy for countering cyclical downswings, a recent speech by François Villeroy de Galhau, governor of Banque de France (, bears mention. According to him, monetary policy should not be the “only game in town …[In fact], it should not even be the first game in town".

Cyclical downswings are characterized by negative output gaps—those between actual output (aggregate demand) and potential output (aggregate supply). The role of monetary policy during such downswings would be to try and bridge such gaps. This involves knowing what is the potential output with a fair degree of certainty, such that a countercyclical monetary policy can push up aggregate demand and bridge the gap.

Recent estimates by the International Monetary Fund, as also RBI, place India’s potential output at 7.1%. With actual output being just 5% currently, India seems to be going through a textbook “negative output gap" environment, characterized by low inflation, employment and growth. If so, RBI can use monetary easing, and—voila!—the cycle should reverse.

The moot question, however, remains: Is potential output 7%, or greater (as it had been estimated earlier), or less? Estimating potential output is as contentious and difficult in India as in other countries. The decennial trend rate of 7.1% provides the estimate for India’s current potential output. This, however, includes the “abnormal" high growth years characterized by high fiscal and monetary stimuli. Thus, the true potential output is likely to be lower than the currently accepted one. Actual output, therefore, may be veering quite close to potential output, albeit at a low level of equilibrium. The problem then may be one of increasing potential output rather than aggregate demand.

Another issue with the use of monetary policy to correct cyclical downswings is that it seeks to address price stability and close the output gap. However, many of the imbalances in the economy are likely to be on account of financial sector variables such as real bank credit growth and real asset market returns, even as inflation remains under control. Increasingly, monetary policy will need to address issues of financial stability alongside those of price stability.

There exist other challenges with the use of monetary policy to impact cyclical downswings. Galhau cites the measurement of inflationary expectations and clarity on the mechanism by which interest rate expectations are formed in an economy as significant black boxes. In India, it has been found that household inflationary expectations are affected by food and fuel shocks (, which are largely temporary. The central bank’s monetary policy, which seeks to accommodate such temporary shocks, will necessarily have to sacrifice output in the medium-run to restore price stability.

An equally important question is: How accurate is the determination of such a slowdown as cyclical and not structural? RBI’s annual report suggests a “broad-based" cyclical downturn in several sectors. However, there remain serious structural issues to address—the sectoral composition of our output, the external sector vulnerability due to our trade composition, our over-dependence on foreign capital flows to meet the current account deficit, the worsening savings-to-gross domestic product ratio, issues of land, labour, and agricultural marketing.

With the current slowdown being adjudged a cyclical one, the temptation to use monetary easing to “correct" the downswing is fairly high. The diagnosis, even if correct, would require estimating with certainty determinants like potential output and inflationary expectations. A greater fear is of the diagnosis being incorrect, and inadequate attention being paid to the more important structural reforms. In either case, RBI should guard itself against the need to display an unwarranted action bias.

These are the author’s personal views.

Tulsi Jayakumar is professor of economics at S.P Jain Institute of Management and Research, Mumbai

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