You recall that the exceptional Rs 60 billion of money creation by the BoM to finance a higher budget deficit -the monetary deficit financing as opposed to Quantitative Easing(QE) by many countries-was met with disapproval from the IMF which considered such financing as a last-resort mechanism, when it is not possible to obtain enough financing from any other source. “Moreover, it should be on market terms, restricted in time, and with an explicit repayment plan over the medium term.” The monetizing of deficits has undermined the ability of the BoM to keep inflation under control .
Let us see how ?
Under Quantitative Easing (QE), when central banks inject money in the banking system by purchasing govt bonds, the private sector willingly holds the newly printed money instead of govt bonds in their portfolios as interest rates are close to or at the zero lower bound. And when inflationary pressures eventually surface, central banks, pursuing restrictive monetary policy independently of Govt, can apply the brakes by reversing QE and selling back Govt bonds to the market.
Our unconventional monetary deficit financing by just adding an entry on the asset side of its balance sheet, or, by holding a zero-coupon non-repayable or perpetual bond issued by Govt is the worst type of money creation because there is less leeway for the central bank to reverse course and apply counter inflationary policies when prices start rising.
Now we have a situation that is witnessing a relentless surge in shipping and material costs, higher energy prices and persistent bottlenecks at ports around the world which have added to the barrage of problems affecting supply chains. Trade experts warned that the supply chain disruptions that threaten to stifle the post-Covid recovery will spill over into 2022 as freight rates soar.
Locally, the depreciation of the rupee and the increase in pretroleum prices are adding to the inflationary pressures from the hike in international commodity prices and freights .( Govt has intensified inflationary pressures by its deliberate policy of excessively depreciating the rupee ).
How is the Central Bank tackling the yr-on yr inflation that has reached 6.5% ? Is the BoM running out of ammunition to contain inflation ? What is the greater risk of a further hike in inflation ?
First, a rapid examination of the main money aggregates shows that the year-on-year growth of the Broad Money Liabilities and the Monetary Base which peaked up to 20% and 78% respectively in April , showed an increase of 19% and 61 % in June- a reflection of the excess liquidity in the market and the problems ahead to contain the inflationary pressures . The growth in the money supply may have an impact in the long run but in the present economic environment with negative output gap or excess capacity in the economy and a combination of a supply and demand shocks ( the high level of household and corporate debts), the Central Bank is seeing the risks of the excess liquidity adding/increasing the price pressures in the current situation as minimal.
Thus, the BoM is not in a hurry to step up its open market operations to mop up the excess liquidity and adopt such measures that will provide an opportunity for the BoM to move decisively towards an explicit inflation targeting strategy. It prefers to kick the can further down the road rather than gradually raise the rates and risk slowing down the economy.
But in failing to convince our business people, investors and consumers that it is determined to contain inflation (by keeping monetary policy loose even as inflation soars) it will be affecting their expectations of inflation. The whole future trajectory of inflation today will hinge on this variable. This is the greater risk to the economy at present. This will unanchor inflation expectations and add to pressures on the rupee. We are thus in for a period of a foul amalgam of further rupee depreciation,higher inflation and economic distress.
