The monetary policy committee (MPC) of the Reserve Bank of India (RBI) decided to leave the policy rate unchanged in its meeting last week. On top of that, the MPC decided to shift its bias from one of accommodation (inclined to cutting rates) to neutral (interest rates can go either way). More than the decision to leave interest rates unchanged, the bias-shift surprised many and annoyed a few. Government of India bonds were sold off and interest rates went up, raising the cost of government and tightening financial conditions somewhat. So, the MPC has ended up effectively raising interest rates. Probably, not quite what the doctor ordered for an economy that is beginning to recover from the massive liquidity squeeze that the government had inflicted on it in November. That is the gripe.
It is not that difficult to defend the central bank’s decisions. Thanks to the flood of deposits that had come into the banking system, banks had already dropped their lending rates on loans and mortgages. Hence, regardless of what the central bank did, financial conditions had eased already. So, a rate cut by the MPC would have been a mere formality. Why waste a bullet when the shot has already been fired by the commercial banks? In any case, interest-rate cuts are not the panacea they are often touted to be.
In fact, in the Indian context, a tightening of monetary policy can always be justified. It is a production-constrained and low-productivity economy. Consumer prices are invariably biased to the upside. A familiar retort is that a central bank monetary policy action would not ease production constraints but might even aggravate them by raising the cost of capital for productive investments. Yes, alleviating production or supply constraints is largely in the realm of fiscal and other economic policies. In the meantime, all that a central bank can do is to restrain excessive demand growth. In fact, in a perennially supply-constrained situation, demand management by the central bank becomes more, and not less, urgent.
As for the central bank’s demand management actions raising the cost of capital for investments, the argument may be conceptually correct but, in reality, cost of capital is often not the decisive factor in influencing investment decisions. Indeed, this column has argued in a recent instalment that many economic phenomenon and policies are asymmetric in nature. The foremost example is that prices and wages are downward sticky. Further, our expectations make many things hygiene factors rather than positive factors that have an impact both ways. Hygiene factors demotivate when they are missing but they do not provide positive impetus with their presence. For example, beyond a certain point and time, wage increases cease to motivate but wage stagnation or even reduction is a big negative influence. Similarly, interest-rate increases may deter borrowing but it is seldom the case that interest-rate cuts, except in ideal conditions, spur borrowing.
In normal economic cycles with normal uncertainty levels, and where borrowers and lenders do not face balance-sheet problems, interest-rate reductions may encourage borrowing. Otherwise not. In reality, investments are mostly determined by underlying demand conditions and profitability estimates. Cost of capital is a peripheral influence. In fact, at extremely low levels, interest rates induce pessimism and reinforce deflationary expectations. This may be hard to believe for many schooled in the belief that, everything else being equal, lower interest rates must spur borrowing. They do not. When set too low, interest rates encourage borrowing for speculative investments, leading to asset price bubbles and eventually saddling the economy with a leverage hangover.
That brings us to the second decision, which is to signal an end to the easing cycle by shifting to a neutral stance, and we will examine the bond market reaction too. While the financial market types prefer that the central bank prepare them for a shift in bias, it is important to remember that these things hardly matter for the larger economy or the public. As Y.V. Reddy used to say, policy certainty and transparency are public goods that central banks are not obliged to offer for free. The occasional non-transparency, opaqueness and surprises are part of the policy arsenal.
Further, the decision is sound from other angles too. Inflation is temporarily lower. There has been a sharp drop in household inflation expectations, as seen in the most recent RBI survey. So, the central bank is opportunistically pursuing its medium-term inflation target of 4% by exploiting the current disinflationary trend and expectations to reinforce it. Far from applauding the central bank’s commitment to its medium-term inflation target, the bond market chose to sulk and register its protest, providing textbook authors with yet another example of its myopia. In its annual report for 2015-16, the Bank for International Settlements has recorded its poor opinion of the bond market’s ability to assess and price inflation and other risks. They will be pleased that the Indian bond market has vindicated them.
The governor of the central bank and the MPC might be new to their jobs but they are learning well. But what about those who took to the megaphones to criticize the institution for allegedly selling out to the government? Perhaps they are on “mute” now that the RBI has shown it has a mind of its own.
V. Anantha Nageswaran is the co-author of Economics Of Derivatives and Can India Grow?
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