Parsing the credit policy

Financial Express, 30 July 2008

RBI is on the right track in raising rates in combating inflation. But monetary policy has made numerous mistakes in the recent period, and continues to have many flaws. These events remind us of the importance of monetary policy reform.

The most important question in thinking about monetary policy today is: What is inflation likely to be over the coming 3-6 months? The overall WPI is overly influenced by administered prices and world commodity prices. Hence, it is useful to use WPI Manufacturing as a measure of domestic inflationary pressures. Simple time-series forecasting suggests that over the coming six months, WPI manufacturing inflation might prove to be at around 9%. This is a conservative estimate in that it ignores future price rises of fertilisers, petroleum products, etc. This projection is made based solely on the momentum in the time-series of WPI manufacturing inflation.

If monetary policy is to contain any semblance of inflation fighting, then the short-term interest rate in the economy has to exceed two percent in real terms. In other words, the short-term interest rate must exceed 11%. This simple calculation tells us that RBI has been behind the curve in understanding and attacking inflation.

RBI has acted too little and too late. Inflation spiked up in December 2007, but in early 2008, RBI was pursuing the policy of buying USD on a massive scale, injecting rupees in the economy, and driving down interest rates in the local economy. Even now - a full eight months into the inflation crisis - policy rates remain negative in real terms. So while there is a lot of hawkish talk from RBI, we should remain skeptical about the extent to which RBI is actually concerned about inflation.

Will raising rates cause a slowdown? There are some sectors which bear the brunt of monetary tightening - e.g. CRR is a tax on banking and raising CRR directly hurts banks. But by and large, India has a weak monetary policy transmission. Changes to the policy rate do not make a big difference to the economy. While the central bank must still be careful to get the policy rate expressed in real terms up to 2% or more, raising rates should not be the central plank of combating inflation.

The tool that actually influences inflation is the exchange rate. A rupee appreciation would impact upon inflation in a way that raising rates cannot. In order to achieve a rupee appreciation, two things are required. First, the capital controls of 2007 on PNs and ECB need to be reversed. Second, RBI needs to announce a program for sale of reserves. This has been done in other countries (e.g. Mexico) where excessive reserves buildup was reversed by systematic sales by the central bank. Selling reserves would do three things at once. (1) It would induce a rupee appreciation and thus combat inflation. (2) It would undo the liquidity conditions which got us into this inflation crisis and (3) It would strengthen the fiscal situation in two ways: the fiscal cost of the petroleum subsidy would be lower given a stronger rupee and the direct cost of MSS would be reduced.

The exchange rate is the tool of choice for combating inflation. It was RBI's focus on exchange rates that got us into this inflation crisis in the first place. Yet, the credit policy document does not say anything about exchange rates. This leads to a loss of credibility, for sophisticated observers know that RBI is being evasive by not talking honestly about the one thing that really matters. If RBI were genuinely concerned about inflation, the speech would start off by talking about how mistakes were made in the past, and how these mistakes will now be reversed.

In recent years, we have experienced a tremendous boom and bust. In 2005, India was riding high and everything looked right. Now, things are bad and everything looks wrong. Sharp changes in inflation and interest rates are roiling the system, making life extremely difficult for finance in general and banking in particular. In this time of pain, we must introspect about why we suffer from this boom and bust.

In mature market economies, this kind of boom and bust cycle does not arise. This is critically related to the sound framework of monetary policy that has been put into place. In advanced countries, monetary policy works smoothly: independent central banks are held accountable for delivering low and stable inflation, and they transparently set about delivering on this task. The macroeconomic environment does not swing about dramatically with five percentage points of a change in GDP growth in a few years. For us in India to achieve this kind of stability, we have to make a break with business as usual at RBI. Monetary policy reform, underpinned in new legislation, is required to put monetary policy in India on a sound footing. That will put an end to this cycle of boom and bust.

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