Reserve Bank of India deputy governor Rakesh Mohan believes that the central bank’s initiatives on the monetary policy front are beginning to bear fruit. In an exclusive interview with Tamal Bandyopadhyay of Mint, his first since the third-quarter review of the monetary policy in January, Mohan says, “(our) initial impressions are they (the RBI’s actions) are having some effect but before I give you an assessment, I need to look at the numbers.” He declines to comment whether the RBI is through with its efforts to regulate money supply. Excerpts from the conversation:
Extracts from the interview:
Is the worst over on the inflation front?
We had started withdrawal of monetary accommodation in 2004. Since then, we have been constantly drawing attention to different inflationary pressures. The points of pressures have been changing. Initially, it was to do with oil prices and metal prices and then early last year people started talking about primary articles and food prices. All the while, we have been guided by two objectives – maintaining price stability and containing inflation expectations.
If you look at the monetary policy stance since April 2004, you will see the slightly changing emphasis on price stability. We are concerned about inflation regardless of the source its source. As a monetary authority, we need to keep a tab on inflation expectations even when it results from exogenous supply side shocks.
In October 2006, we gave considerable attention to analyze the possibility of emergence of overheating. In addition to price rise of food articles we drew attention to increase in prices of manufactured goods and tried to assess whether there was some amount of excess demand and increase in certain assets prices. We are operating on both ends -– taking the monetary policy action in terms of freezing the policy rates and also reducing the liquidity in the system through hike in banks’ cash reserve ratio (CRR). We are also acting on those areas where credit growth seems to have been very high. We are acting all on fronts – overall liquidity management, interest rate policy actions and prudential actions in certain sectors (by raising capital requirements and provisions).
Are you seeing the result of these actions?
As you know, monetary policy actions do not give results overnight. First of all, we have drawn attention to the possibility of overheating. It is very difficult in developing countries that are undergoing structural changes to actually identify overheating…. Even when macro resources adequately support a certain potential growth, you can still have transitional problems in supply rigidities… For example, given many difficulties that are well known in terms of infrastructure, various supply side problems in terms of availability of land, urban regulations and so on that even when our assessment talks about overall availability of resources, we can still have transitional problems which manifest themselves in indications of overheating. In an open economy, ideally we should not observe prices rising higher than international prices. However, if we look at the data carefully, we will find that the price increases are higher in exactly those kinds of goods that are not easily substitutable or easily importable even though they are open for import. This itself gives an indication that there is some degree of transitional excess demand because it takes time for capacities to come up.
So, no result of your action so far?
We expect that our actions will yield results but as you know monetary policy actions take time and we would expect the consequences of the cumulative actions that we have been taking for the last two years as well as our recent actions.
Are you through with your actions?
As I have said, one would expect to see results of we have done over the last few years and the current measures in terms of liquidity management.
Does that mean no more action from RBI?
Let me repeat: One would expect the cumulative effect of the monetary policy actions that we have taken… We will take any action that is necessary to make sure that inflation expectations are contained.
Your targets for money supply and even inflation may go haywire this year.
We don’t set the targets. One of the things that I have learnt after coming to the central bank is that we use words very carefully. We have made “projections” and some of the monetary projections have been exceeded. We are in the process of evaluating the methodology of the projections and will see whether any changes are required.
Is the inflation tolerance level going down or are you over-reacting?
A very good point. We had 7-8% inflation rate for 40 years from mid- to late-1950s to mid- to late-1990s. For last eight to nine years, we have an average inflation rate of 4-5%. We used to very excited when the inflation was above 10%. And now we get excited if it goes above 6% or so. For a central bank, this is welcome because it shows that there is some success in bringing inflation expectations down. We will build on this success and keep price stability as a priority area. To some extent, our task has become easier.
So, you’re giving a thumbs down to growth?
What was the average inflation from the mid 1950s to mid 1990s? Seven to 8%. And the average growth was 4-5%. Over the last ten years, the average inflation rate has been 4-5% and the average growth rate has been around 7%. What is the association between inflation and sustained growth? For sustained growth price stability is extremely important. Obviously, with low inflation, there will be lower interest rate and with less volatility (in prices), investors have less risk. So with low inflation, low interest rate and low volatility, we are likely to get more sustained investment. We believe that in order to sustain and maintain medium and long-term growth, it is of utmost importance that we keep inflation down and inflation expectation down.
What are the risks ahead?
Internationally, oil price volatility remains. Increases in international food prices are also a concern. The Australian drought of last year will affect the wheat prices… Because of high energy prices, in the US, Brazil and some other countries more and more acres of land is being used for producing bio-fuel. This is putting pressure on food prices.
The global imbalances remain but I must say that the concern level is lower than what it was a year ago.
Finally, what we had seen last May and even a couple of weeks back – small events in the financial world can lead to large fluctuations in capital markets in asset prices and exchange rates. This is one way to understand that in the world to the extent that we have low interest rate and low inflation, a small change can induce a large change in asset prices. One of the endemic risks is small changes can have large volume effects. We will have to be more concerned about financial stability domestically.
Between 2001 and 2005, there was a worldwide increase in monetary accommodation. In US, Japan… everywhere there was huge liquidity overhang. Any standard monetary theory says that monetary overhang must result in higher inflation. Has something changed in this world? There has been a big debate on this internationally… The US has even stopped compiling monetary aggregate measures… One view says there is no need to look at monetary aggregates..
Aren’t you going the same way, specially when your projections on money supply are wide of the mark?
We have not solved the debate as yet. This is something we need to look at. All of us are trying to answer the question whether the worldwide monetary overhang will lead to higher inflation rate or whether that has manifested itself in the asset prices internationally.
What are the domestic risks?
On the positive side, the kind of monsoon we have last year, there will be a lot of moisture on the ground and so we will have a good rabi crop which will moderate the food prices. After talking to bankers we understand that there is a good deal of investment activities taking place and also that the project completion time has shortened. The risk is: How long will it take to resolve some the supply side shortages.
Are bankers going slow on credit disbursals?
We are still discussing these issues. We are processing the numbers. The indications that the bankers are giving is that the monetary policy action is beginning to bear some fruits but we still have to watch.
So, credit growth is slowing down?
We still have to watch. Initial impressions are they (the policy measures) are having some effect but before I give you an assessment, I need to look at the numbers more carefully and complete the round of discussions. The assessment will be made public next month when we announce the annual monetary policy.
So, we can expect no more action between now and April 24 when you announce the monetary policy?
We will respond quickly as and when our assessment suggests that we will have to respond.
The liquidity in the system that we see is your doing. You are buying dollars and creating liquidity and then undoing it by raising CRR…
There is no doing or undoing …We are managing liquidity. Look at the paragraph 89 of the third quarter review of the monetary policy (he gets up, picks up the document and starts reading it): Over the remaining part of the year, management of liquidity would receive priority in the policy hierarchy…. Consequent to the tightening of market liquidity, the impact of monetary policy is expected to be stronger than before. The Reserve Bank would use all policy instruments, including CRR, to ensure the appropriate modulation of liquidity in responding to the evolving situation.
What I want to emphasize is that the policy statements are written very carefully and we try to provide as much transparency as possible. We said deliberately in the statement that liquidity management would receive highest priority and we would use all instruments. That is what exactly we are doing.
You have serious differences with the finance ministry...
I don’t think so. Where do you see differences? We are saying the same thing – continuation of the growth momentum and keeping price stability.