Can this apply to India’s inflation conundrum today? On the one hand, the government has argued that inflation is cost-push driven, resulting from supply shortages—hence, by increasing interest rates or stifling liquidity we cannot generate more rice and pulses to bring down prices. Monetary policy should, therefore, continue to be supportive. On the other hand, Reserve Bank of India’s (RBI) spokespersons have at times spoken of policy options to control inflation. So which one is it?
It is true that monetary policy cannot bring in supplies, but it is also debatable whether increasing rates today will affect investment. This is because if opportunities are there, businesses will invest, notwithstanding higher interest rates —just as steel producers do not stop investment merely because the price of electricity or ore increases. But, for the sake of argument, let us assume that higher rates can spoil the party while the economy is looking to grow now by 7.75% this year. What should be the approach of monetary policy then?
Illustration: Jayachandran / Mint
First, on the one hand, shortages in supplies will automatically exacerbate the demand-supply imbalance at the macro level and lead to excess demand forces, even if demand per se remains unchanged (the same number of people vying for fewer goods). On the other hand, if we believe in the 7.75% growth story, there will be latent inflation, since demand-pull pressures will build up. There is, then, a need to pull the trigger. Either way, there is a case for monetary action to check inflation. Perhaps RBI knows that already: Its response to inflation in mid-2008 was to increase rates and reserves, even when inflation was predominantly on the supply side.
Second, theoretically, monetary policy should be forward-looking. Policy actions take time to work for both growth and inflation. Therefore, if we are expecting inflation to rise in the future—even if it is not engendered by excess demand —monetary action is required to pre-empt it.
That makes a strong case for RBI intervention. Reducing liquidity through a hike in the cash reserve ratio (CRR)—the reserves banks set aside—is a way out. But such quantitative measures are less preferable in a market economy with thousands of separate actors who may react differently, and should be the last resort. We can draw an analogy from foreign trade: Tariffs cause fewer distortions than a quota and are, hence, superior. Therefore, an interest rate hike, which can specifically target banks’ ability to lend based on market forces (higher rates lower the demand for credit) is preferable. Changing the cost of credit is better than lowering the quantum of funds through CRR.
The debate over the use of monetary measures raises the question of whether or not monetary policy itself is being abused. Economics’ Rational Expectations School advocates a simple approach, where the authority announces the targets and sticks to it during the year. Given the availability of perfect information to all market participants, the University of Chicago’s Robert Lucas and New York University’s Thomas Sarjent argued that government policy would not really be effective. As a corollary, the only way in which policy would work would be in case the government systematically fooled the public by changing policy measures by going in for “fine-tuning” later.
Therefore, if we started off with, say, a CRR of 5%, everyone would adjust to it. But, now, by altering CRR or the repo rate unexpectedly, we would contrive to make our policy work by “fooling” the public. RBI may just have done this in the recent past: In the first half of 2008-09, it countered inflation by aggressive action, which stifled the growth process. Subsequently, in the second half, it did an about-turn to revive the economy. From the point of view of expectations, it would have been better off not doing anything.
This is relevant because RBI’s policies have an impact on the market—and one is not sure if RBI works independently or is influenced by the Prime Minister, the finance ministry, the Planning Commission or the Prime Minister’s economic advisory council. Every statement made by any of these authorities swings the market because there are expectations that RBI will follow suit. Further, RBI’s governor and the deputy governors have their own say, often prompting speculation or expectations, which then tend to be self-fulfilling. News of a rate hike can move the bond or call money market substantially as there is, on average, Rs50,000 crore of trading guided by these expectations.
The question is whether or not this array of authorities should be providing signals and whether we are to take them seriously? Ideally, if we believe in the Rational Expectations School, RBI should not be having so many policy statements. But the concept of fine-tuning has led it to four policy announcements a year. Moreover, some governors have made it a habit to make announcements between policy statements, thus making the exercise potentially destabilizing.
One solution to reduce uncertainty is to set “intervention thresholds” during the year. RBI can set triggers such as point-to-point inflation crossing 6% or non-food inflation crossing 4% as potential intervention points. Theoretically, we need two instruments for two objectives: A Keynesian approach to fiscal policy will address growth, while the monetarist position will tackle inflation. By letting this known, we also pay obeisance to the Rational Expectations School, thus making the policy combine, to borrow a metaphor from the ice cream parlour, three-in-one economics.
Madan Sabnavis is chief economist, NCDEX Ltd. Views expressed here are personal. Comment at email@example.com