MONETARY POLICY ON INEQUALITY

1. Context 

2. Key Points

• Since May last year, the existing EMIs for home loans, car loans or loans for business have been going up quite rapidly.
• This has been happening because the RBI has been repeatedly raising something called the repo rate.
• The repo rate is the rate at which the RBI lends money to the banking system.
• A hike in repo implies that banks and other financial institutions charge higher interest rates.

3. Reasons for raising interest rates

• The RBI has been doing this in its bid to contain inflation.
• RBI hopes that a higher EMI on an existing loan or a costlier new loan would dissuade enough people from borrowing money to fund future economic activity.
• The resultant slowdown in activity and demand for money will likely bring down inflation, which is essentially described as "too much money chasing too few goods".
• Since the RBI, which is the main agency charged with the responsibility of maintaining price stability in the Indian economy, cannot increase the supply of goods and services such as crude oil, cabbage and haircuts, it acts in a manner that reduces the demand for all goods and services.
• This week, too, it is expected that the RBI will end up raising the repo rate by 2 basis points.
• But just like the past two repo rate hikes in February and December, this decision is unlikely to be a unanimous one; More importantly, it will likely be widely debated for soundness.
• That's because both within the MPC and outside, many believe that any further rate hikes will result in crimping India's economic growth and worsening unemployment.

4. Pros and Cons of raising interest rates

• The main problem with hiking interest rates to contain inflation that may be getting caused by costlier crude oil (due to war or some geopolitical tension) or costlier vegetables (due to some unseasonal rains) is that the hike per se cannot improve the supply of those goods and services.
• Raising rates is, in no uncertain terms, a blunt instrument. It achieves the goal of containing prices by killing growth and employment. Many have questioned this approach in the past.
• The standard textbook answer to this criticism is: A central bank does this not so much to address the actual inflation which it can't control if it is driven by supply constraints but to prevent the  "Second-order effects" of high inflation.
• The second-order effects refer to a spike in people's expectations of future inflation. 
• This matters because if people do not see inflation as a minor blip and instead view inflation as here to stay and likely to worsen, they will do what any normal person should be expected to do: Ask their boss for a salary increment.
• But, this can quickly turn into a self-fulfilling prophecy. If workers are allowed to demand higher wages in anticipation of higher inflation, then businesses will start charging higher prices in anticipation of higher input costs (real wages).
• Lo and behold, the economy will find itself in the middle of persistently high inflation.
• It has been shown that once inflation expectations become "unanchored" in this manner, policymakers find it quite tough to bring down inflation.

 5. The problem with breaking this cycle of inflation expectations

• The trouble is, and this is one of the relatively ignored aspects of monetary policy, that inflation control by this method relies heavily on denying the common people, who are most affected by high prices, the chance to raise their wages in line with the already high prices of the first round.
• Worse still, higher interest rates make it difficult for the relatively worse off to get cheap credit to buy a home and create wealth.
• In essence, a contractionary monetary policy the kind being practised the world over at present essentially increases inequality in an economy.
• To be sure, inequality is the distance between the haves and the have-nots in any economy.
• In an academic paper published in January by the Federal Reserve, the board shows that " equality of access of the most important asset class for most households are also dependent on monetary policy.
• The tighter policy leads to greater inequality in ownership, in contrast to the literature that finds reduced wealth inequality based on asset prices.
• The effects of homeownership on wealth take time to accumulate, so the influence of this access channel on wealth inequality would accrue only with a considerable lag.
• When the US Central Bank raises interest rates, it places something as basic as home ownership out of the reach of common people.
• This reduces the people's ability to have access to an asset that creates wealth and this "wealth inequality" (relative to the wealthy) hits the poorer people with a lag.

6. Raising interest rates creates inequality

• From the 2008 Global Financial Crisis until the war between Russia and Ukraine, most central banks, most notably the US Fed, practised an expansionary or loose monetary policy. 
• Essentially, this meant interest rates were kept low (almost near zero in the case of the US Fed) while flooding the economy with additional money in a bid to spur economic activity.
• But during this period, there was growing criticism that low-interest rates were leading to higher wealth inequalities.
• When interest rates are low, savers barely get any rewards even as cheap credit-fuelled spending, profiting companies of different kinds. 
• Under the circumstances, most of the capital appreciation happens in the stock markets.  Most of the stocks in the economy are owned by rich
• The view that low-interest rates widen inequalities is quite widely held even among experts associated with the IMF and the US Fed.

7. Central bank's action 

• Given the pernicious effects on inequality of both a contractionary as well as an expansionary monetary policy.
• The widening inequalities are a very long-term trend, one that has been decades in the making and depends on deep structural changes in any economy such as globalisation, technological progress, demographic trends etc.
• By comparison to the influence of these long-term factors, the effects of monetary policy on inequality are almost certainly modest and transient.
• Monetary policy, if properly managed, promotes greater economic stability and prosperity for the economy as a whole, by mitigating the effects of recessions on the labour market and keeping inflation low and stable.
• Even if it were true that the aggregate economic gains from effective monetary policies are unequally distributed, that would not be a reason to forego such policies are unequally distributed, that would not be a reason to forego such policies.
• Rather, the right response is to rely on other types of policies to address distributional concerns directly such as fiscal policy taxes and government spending programmes and policies aimed at improving workers' skills.
• Policies designed to affect the distribution of wealth and income are appropriate, for the province of elected officials, not the Fed.

8. The Way Forward

• More research is needed to untangle the issue and the role of monetary policy and the job of central bankers.
• The uncertain distributional impact of monetary policy should not prevent the Fed from pursuing its mandate to achieve maximum employment and price stability, thereby providing broad benefits to the economy.
• Other types of policies are better suited to address legitimate concerns about inequality.

For Prelims & Mains

Previous Year Questions