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Wednesday, April 04, 2007

A difficult time for Monetary Policy

Monetary policy in India has continued to lurch from one difficult situation to the next. Last Friday, after the market closed, RBI came out with a series of monetary policy decisions even though it was not scheduled to be an MPC date. A stream of interesting reading has appeared on the subject.

On Monday morning, Ila Patnaik wrote an article in Indian Express and there was an edit in IE at the same time. The stock market dropped 5% that day - the RBI announcements were clearly bad news for India. Update (9/4): Former RBI Governor S. Venkitaramanan has written an opinion piece in Hindu Business Line responding to this.

Rajiv Malik has written a piece Poorly timed shock therapy in ET. FE had a good edit about the decisions. Jaideep Mishra has a plea for transparency of monetary policy.

When monetary policy fail to deliver the goods on price stability, politicians are distraught and think of listening to quacks - the UPA has come up with a series of supply side interventions. ET has three good pieces on this by Amit Mitra, Shubhashis Gangopadhyay and Partha Mukhopadhyay.

What do I think?

  1. I think there is no tradeoff between growth and inflation in the long run. It is perfectly feasible to have stable 3% inflation and 9% growth for a decade. If anything, I think that high inflation and high inflation vol will drive down GDP growth.
  2. I think the acceleration in the CPI-IW from 3% in 2004 to nearly 7% today is hugely disappointing and that it is very important to obtain stable 3% inflation. With this inflation vol, the long-dated INR bond market is doomed, which has many disturbing consequences for the financing of long-term projects in India - long term projects will be forced to hold low leverage or engage in original sin (i.e. currency mismatch). Update (14/4): Financial Express has an edit on this dimension.
  3. I think that real rates remain too low to slow down inflation.
  4. Thus I would be happy with a monetary tightening, if it were done.
  5. I think it isn't being done. (See my piece What RBI Wants in BS today.)

All in all, it has been an unhappy set of weeks for RBI. As the editorial in Economic Times said on Monday (2nd):

What is more certain is that its latest move has not done anything to enhance its credibility as a central bank. Rather the feeling is of a slightly panicky monetary authority that is not quite sure how to handle the situation; a view that is bolstered by its conflicting signals on the exchange front.

A day after the bank seemed to have decided to limit its intervention in the forex market, allowing the rupee to appreciate to an eight-year high, it was back in strength. The rupee promptly lost 70 paise in a day. Not all Germans believe in God, but they all believe in the Bundesbank, said former European Commission President Jacques Delors. After the latest move, it will be a some time before we say anything similar about the RBI.

To think effectively about the situation, it is important to think that RBI is a set of high IQ people with considerable competence. Let's be neoclassicals and always attribute intelligence and drive. So it behooves us to ask: What are they maximising?

Central banks are not autonomous creatures that run monetary policy based on their own views. They are agents of Parliament. The RBI Act of 1934 is the contract under which Parliament has outsourced the task of doing monetary policy to RBI. RBI is the agent, and Parliament is the principal. In this setting, much insight is obtained by thinking about the principal-agent problems. What are the agency conflicts of the present contractual structure? How can these agency conflicts be eliminated?

As of today, this contract is poorly drafted. If you ask RBI "Why did you not contain inflation?", it can give you numerous plausible replies. He can say it was because you burdened him with bond issuance for the government (low interest rates were required to subsidise bond issuance), or banking regulation (low interest rates were required to protect banks), or currency objectives (low interest rates were required to deter capital flows).

If RBI's conduct is confusing, it's because the outsourcing contract is poorly drafted. It leaves RBI with tremendous leeway to exercise its own discretion on choosing what monetary policy ought to do, and it leads to a loss of accountability - when you are expected to do two things, you are free to do neither because you always have an excuse.

Hence, I have repeatedly argued that the need of the hour is a redrafting of the outsourcing agreement, to achieve a simple framework where there is complete clarity on what RBI has to do. This redrafting of the RBI Act needs to bring in a framework of transparency, accountability, independence and focus. Better contracting between government and entities outside government is being done in many fields - e.g. CEOs of PSU banks will get bonuses when they do well. RBI will change its behaviour when the governor gets a bonus based on how well he achieves an inflation target.

It is fashionable to criticise RBI these days. The real problem lies not with RBI but with Parliament and the Ministry of Finance. The Ministry of Finance has not woken up to the dangers of running monetary policy in the India of 2007 based on a 1934 outsourcing contract that is ultimately animated by policy thinking over 1913-1926.

Update (6/4): Jamal Mecklai has a great piece in Business Standard on the subject of RBI reforms and the monetary policy regime. And (10/4), Suman Bery summarises recent discussions and suggests that greater exchange rate flexibility is the key. Update (11/4): an editorial on these debates in Mint.


  1. liked your piece in BS. i'm not sure that mutiple objectives is rbi's failing. the fed too has bank regulation and other madates apart from it's original goal so it's far from certain that a performance bonus is a solution.

  2. From RBI's website: "Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors"

    So, I guess the markets should expect them to behave in this way and then themselves behave in accordance.

    Central Banks all over the world have this mandate on price stability. eg Bank of England - inflation target of around

  3. Is the call money rate analogous to the 'federal funds' rate set by the Fed?

  4. I feel what Ajay is saying is right. Ila Patnaik's article explains the economics of it and that too in plain and lucid manner.

    It is true that RBI's actions have been ad hoc at best. A transperent forex trading platform is what we need and I completely agree with what both Ajay and Ila are saying

  5. Couple of questions:
    1)While a revamp of the mandate of the RBI and a better decision making process in terms of a MPC may be well required, will it actually work without a vastly better sysytem to measure and collect data on the real economy?The problems with the national statistical system we have are well known..But we still continue to have economists/statisticians in India who bask in the 1950s glory of the Mahalanobis instituted system without having to face international/peer review..I find it quite amazing that we still have debates in India over the number of people who live in poverty or that people question the validity of industrial production data..Don't you think having the amamzing wealth of data on the economy that is available in the US or Europe not just helps the central bank in taking better decisions but also helps market participants to analyze/dissect the data and form independent opinions without having to depend on the wise men of the MPC?

    2)Do you fully dismiss any benefits that active management/undervaluation of the exchange rate may have on the economy??Surjit Bhalla has presented data to show that the mercantalist approach of undervaluing the exchange rate (albeit the real, not nominal one) has been a significant explanatory variable of growth across countries..Aren't there situations where an undervalued rate may lead to greater demand for exports leading to greater investments by firms and hence greater growth and employment??There are people who theorize that China has been using the undervalued CNY to essentially move people out of low productivity agriculture to high productivity industry/services..Can such a regime coupled with reasonable capital controls (not the draconian ones we have in India)actually lead to significant benefits in the medium/long term??

  6. Doc,

    Why, do you think, the central bank considers the rising INR -- an anathema, when learned ones like yourself, Dr. Ila et al, endorse the approach?

    There must be some reason.

    Considering the fact that the RBI's functioning in the recent past has 'appears' reasonably independent !

    R. Shankar
    L&T Infotech Ltd.

  7. your piece in the business standard is wonderfully well written. As someone associated in the forex markets i can tell u the market has no clue what the RBI wants( like the 50 cent hip-hop songs goes). How can a central bank be in control when it creates so much confusion in the market. Just as the Flambayant Mr Mecklai says USD/INR can be as low as 38 or even 45. No one has a clue. If this is for the benefit of exporters ...this kind of volatility is anyway never going to help anyone. And what is the rate they should be talking as their budgeted rate for this year in case they are planning to hedge? remember we are having a currency which is moving more in percentage terms than the sterling.

  8. I'm not sure, in the long run we can have a very huge gap between inflation and growth rate. While, in the short run (that could even run for a couple of decades!) efficiency gains and technology change could fuel great growth with little inflation (like during 1960's and 90's in US) the fundamentals would get back after a while.

    Because, growth creates money that must be stuffed somewhere. Countries either spend on consumption (US) or use it on saving (Japan). If you consume more, you will cause inflation, and if you export more you need to introduce greater money into the market to mop the dollars (with pegs) and will cause inflation. Japan is a peculiar case that violently resisted inflation while acheiving super growth, and now is going to be torn apart by its own runaway growth (if dollars goes on a free fall, Japan is screwed). You cannot escape from reality for far too long.

    Coming back to Indian policy, I believe RBI is doing the right thing, albeit a bit too late. It is allowing rupee to appreciate and increases the interest rates. By introducing trillions of rupees in the last decade to buy the dollars, RBI has greatly contributed to liquidity and core inflation and now by reducing the buy, it could plug the hole a bit. And rupee appreciation will also cause inflationary 'effects' to go down by causing prices of imports to go down.

    And interest rate hike will discourage the consumers to stop buying the rat-hole apartments at the prices of an elephant resthouse. I cant believe that I could easily afford a home in an "expensive" Seattle market, while not even a small apartment in a Chennai suburb. On a more serious note, real-estate prices are hurting everybody from office-space developers, 5 star hotel developers and retail businesses. If interest rates could cool real-estate market, it could infact aid growth in these sectors that are very crucial for further growth. Inflation of 6% hardly reflect the fact that real-estate, office and home prices in many crucial markets have appreciated 300% in 3 years.

    Interest rate hikes will have minimum effect on major corporations because they have huge access to foreign liquidity, and sectors like auto, metals and pharma can easily offset a cooling in domesting consumption by exports even with a stronger rupee.

    Lastly, it will introduce better fiscal and finacial responsibility from government and the people respectively. Indians have hardly much retirement accounts or social security, and its time to pull the people into more savings and lesser personal loans. This could be done only at the time of prosperity like this. A 10% rate will encourage people to save more, and take credit more responsibly which will benefit us in the long term.

    I believe growth rates, inflation and interest rates would always be aligned in the long-term, with interst rate a point above growth rate, and inflation a couple of points below growth rate.

  9. To a man with a hammer, everything looks like a nail!

    Would it not make sense to examine the drivers of inflation? Key issue here is food grain prices and there its a supply issue. We can argue about how best to solve that but it will be helpful to start from there. Your article and most of the folks you have referred to seem to see interest rates as the only policy instrument available to curb inflation.


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