It's the currency, stupid

What is the impact of changing the policy rate?

The `monetary policy transmission' is about changes in the short-term policy rate reaching out and influencing the economy through changes in all interest rates. But this requires a well functioning Bond-Currency-Derivatives Nexus. By preventing the Bond-Currency-Derivatives Nexus from coming about, RBI has rendered itself ineffectual. The impact of changes in policy rates upon the borrowing and lending rates of banks, and on the corporate bond market, is small. The impact on the economy is rather small given that banking and the bond market are pretty small when compared with GDP (as a consequence of policy mistakes).

Absent the BCD Nexus, changes to the short-term policy rate don't do much to affect the economy. So even if the right thinking was put into place for setting the short rate, this wouldn't do much to shake the economy. The short rate is more usefully seen in the context of interest rate differentials and exchange rate pegging; it isn't much of a tool for influencing aggregate demand in the economy.

To say this in more technical terms, if you try to do the standard models looking for a monetary transmission, you don't see much happening in the economy when the short rate is changed. Recall the draconian interest rates that were required in the mid 1990s to squeeze inflation out. The extreme measures that were required convey the extent to which the tools that RBI controls are relatively feeble. In a mature market economy, with a properly setup monetary policy framework, modest changes to interest rates would get the same job done. We had to resort to draconian things in the mid 1990s in order to combat inflation because small changes just didn't get the job done.

What can RBI do to tame inflation?

Given that the Bond-Currency-Derivatives Nexus isn't in place, and that changing the short rate can't easily influence inflation, the only effective instrument that RBI has to reduce inflation is a rupee appreciation.

So what is the credit policy announcement and what is the monetary policy?

Given that India runs a pegged exchange rate with increasing de facto convertibility, what really matters in defining monetary policy is currency trading. Monetary policy is effectively now played out every day, under a shroud of non-transparency, in RBI's trading on the currency market.

There is no publicly visible policy document about what is done there and why. No data is released on a daily basis about what was done there. FIIs tell us more about their actions than RBI does.

The very public credit policy announcement is a show that emulates central banks in mature market economies. It distracts attention away from the true story which is currency trading. It does not illuminate what is going on in monetary policy. If no show took place, your information set would not be substantially altered. Despite the show, RBI is one of the most opaque central banks in the world.

Journalists are blindly imitating what they see in the US and the UK in covering it. But we in India do not have the monetary policy framework that is found in a mature market economy, and it would help if we all took this show less seriously.

Some useful reading material

With these health and safety warnings out of the way, here are some materials that are useful for parsing the credit policy announcement:

• A four part `Reading Reddy' series in Financial Express: I. Ila Patnaik, II. Indranil Pan, III. Dominique Dwor-Frecaut, IV. Rohini Malkani, Summing up
• The case for a rate cut
• Four concerns for central bank by Anup Roy, in Mint.
• An editorial in Indian Express.