Monetary Policy: Mythili Bisnurmath: ET Blog
Reading Your Lips, Guv
|Also read my online comments at the end|
Let me start by saying I have no quarrel with the Reserve Bank of India (RBI) governor, Raghuram Rajan’s decision to hike the repo rate by 25 basis points to 8 per cent last Tuesday. Like most middle class readers of this paper, who have watched their hard-earned savings get eroded by negative real interest rates over the past few years, like the governor, I believe there is no trade-off between growth and inflation in the long run.Same Difference
So my quarrel is not with the RBI trying to set inflation on the path for disinflation. My quarrel is with the RBI’s apparent lack of consistency; with its advancing broadly the same macroeconomic fundamentals to justify two contrary decisions. Read the latest policy statement.
Compare it with the 18 December 2013 statement when the governor chose to keep policy rates unchanged and it is hard to find any justification for Tuesday’s decision to hike rates. As Rajan himself put it, ‘Last time round, it was a close call, but we chose to wait. This time, again, it was a close call; but we chose to act.’ Why?
Prima facie there is no answer. Almost every reason given by the Bank to justify the hike in the repo rate in January 2014 – CPI inflation at close to double digits, sticky core inflation, elevated inflation expectations, wage pressures – was a factor in December 2013 as well.
But even as it accepted that the ‘high level of CPI inflation excluding food and fuel leaves no room for complacency,’ in December 2013 the Bank found ‘reason to wait before determining the course of monetary policy.’
There were ‘indications that vegetable prices may be turning down sharply…In addition, the disinflationary impact of recent exchange rate stability should play out into prices. Finally, the negative output gap, including the recent observed slowdown in services growth, as well as the lagged effects of effective monetary tightening since July, should help contain inflation.’
The ‘weak state of the economy, the inadvisability of overly reactive policy action, as well as the long lags with which monetary policy works,’ meant ‘there is merit in waiting for more data to reduce uncertainty.’ Then the argument looked weak. Inflation had touched a record high. But the RBI chose to ignore the weight of months of data showing entrenched and elevated inflation expectations in the hope that a single data point one month later would show inflation trending down.Softer Prices
Most observers, however, were willing to give the RBI the benefit of doubt. After all, monetary policy is a blunt instrument; the current bout of inflation in India is largely supply-driven and the economy has slowed.
And sure enough, when inflation numbers for December were released, mid-January 2014, skeptics, like this columnist who believe the Bank should have persevered with its earlier bout of tightening, were forced to concede that the governor seemed to know his onions. Inflation was trending down. It was time to call a halt to rate hikes.No Rules Framework
When vegetable, including onion, prices did decline sharply and CPI inflation contracted from 11.16 per cent in November 2013 to 9.87 per cent in December 2013, why did the RBI hike rates? Defending his action, Rajan pointed to how core CPI inflation has remained flat and core WPI inflation, has risen. But is that reason enough to warrant a hike in the repo rate?
Not if one were to go by the Rajan’s yardstick laid out only a month earlier: The bank would act ‘if the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation, excluding food and fuel, does not fall.’ Consider. The first requirement of this two-part caveat had been met by late January 2014.
Food inflation has softened. There is a significant reduction in headline inflation. Core inflation, a concept popular in advanced countries, has no salience in India where food and fuel account for a major share of the consumption basket.
What is the logic in ignoring what happens to inflation in a major chunk of the consumption basket and focus on the balance while framing policy? The answer is, ‘none’, not unless one views the decision as the outcome of RBI throwing its weight behind the Urjit Patel committee’s prescription of inflation targeting. There are a number of problems with this.
Not only because the jury is still out on the benefits of inflation targeting. Or even because the fisc in India is wildly out of sync with the pre-requisites for such a policy. But because a rule-based framework allows little scope for discretion, judgment, institutional memory; indeed any of the reasons the governor relied on to swing the ‘close call’ one way in December 2013 and the other in January 2014.
Central banking in the brave new world of tomorrow is much too complex to allow rules to substitute for judgment. Not when central banks have to keep an eye on no less than three major objectives – price stability, macro-financial stability and yes, growth.
February 07,2014 at 08:45 AM IST
Though I find myself unprepared to comment on the text of this article, as a ‘generalist’, I have no hesitation to endorse the conclusion which reads: “Central banking in the brave new world of tomorrow is much too complex to allow rules to substitute for judgment. Not when central banks have to keep an eye on no less than three major objectives – price stability, macro-financial stability and yes, growth.” Probably, policy statements(even those made by RBI Governor Dr Rajan or FM Chidambaram) are not amenable for comparisons of the type attempted in this article. Still, reminders like this will keep the system alert.
ET Posted on February 7, 2014