What a batsman on a seaming wicket can teach RBI
4 min read 12 Jul 2022, 10:35 PM ISTMonetary policymakers face uncertainty on the inflation trajectory as well as the effects of price expectations and rate hikes
PremiumCentral bankers today face a dilemma that is very similar to what a batsman playing on a seaming wicket sometimes faces. A batsman who decides to play on the front foot can reach the ball before it swings, but there is a risk of misreading the movement. A decision to play on the back foot has the advantage of being able to watch the ball till very late, but at the risk of being forced to play a hurried shot.
This striking analogy was first made by Andrew Haldane in 2014, when he was chief economist of the Bank of England. Taking policy decisions in an uncertain economic environment is mostly unavoidable. However, the dilemma is even more acute these days when the ball is swinging even more than usual. The Reserve Bank of India (RBI) is one of several central banks that has to take policy decisions under great uncertainty.
There are three major sources of uncertainty right now—about the trajectory of inflation in the coming months, the way high inflation will affect the decisions of participants in the economy, and how changes in interest rates will affect the economy. Each has profound consequences on monetary policy right now.
The first uncertainty is about inflation. Most central banks misread the tea leaves, and were late in responding to resurgent price pressures in their economies. The initial delay in moving has necessarily meant that more harsh options are now being considered. The sharp decline in several key commodity prices in recent weeks has now raised hopes that inflation has already peaked, though it is still above the inflation targets or comfort zones of most monetary authorities. (Or is it an “inflation whipsaw", in which the direction of prices can change almost overnight?).
Monetary policy affects the economy with a lag of about a year, so what a central bank does today has implications for the economy much down the line. That is why forecasts of the economic situation a year later—especially inflation—matters so much for the practice of central banking. However, when forecasts have generally been wrong because of uncertainty, it perhaps makes more sense for a central bank to depend more on the latest price data rather than a forecast, at least till the fog dissipates.
The second uncertainty is how participants in the economy are responding to inflation, especially households and the private sector. A burst of inflation is likely to see demands for higher wages from workers who are trying to protect their standard of living. We see this happening in many rich countries right now. The Indian situation is different as of now. Wage growth is muted. Economists often speak of how the demand for higher wages will increase costs, which would then spark off further demands for higher wages, leading to an upward spiral of inflation.
The same can happen with the decisions of firms as well. They can either decide to absorb higher input costs or pass them on to consumers. That will generate its own inflation dynamic. A lot depends on the relative bargaining power of wage earners and firms in such a situation. However, a lot also depends on the underlying psychology, or inflation expectations. If participants in an economy, be they households or firms, believe that the current bout of inflation will be brought under control soon, then they are likely to behave as if inflation will be temporary. Their expectations will be stable. Whether they respond quickly to price pressures or decide to show patience depends on the credibility of the central bank. The less the credibility, the more likely that an inflation shock will change behaviour on the ground, and the greater the need for strong action to keep inflation expectations anchored.
The third uncertainty is about what effect interest rate hikes or the withdrawal of liquidity will have on economic activity. There are times such as these that the relationships between economic variables temporarily break down—or what is described as ‘parameter uncertainty’ in technical language. In a paper he wrote in 1967, William Brainard had shown why central banks facing parameter uncertainty should move cautiously, since they cannot be sure how their actions will affect prices and employment. This is the famous Brainard conservatism principle.
European central bank head Mario Draghi put it in simpler terms in early 2019: “[T]he fact that the climate has become more uncertain doesn’t mean that one has to stay put. You just do what you think is right and you temper, however, what you are doing with a consideration there is uncertainty. In other words, in a dark room you move with tiny steps." The world has become far more uncertain since he uttered these words, what with a global pandemic, supply chain disruptions, a massive global stimulus and the war in Ukraine.
There is no doubt that central banks did not anticipate such a sharp rise in inflation, and now have to make tough calls on whether to move cautiously because of the uncertainty or aggressively to quickly bring inflation back into their mandated comfort zones. Underlying these decisions is also the issue of how much output will have to be sacrificed to control inflation, which in turn depends on how far inflation in each country has strayed away from the target as well as the slope of the Phillips Curve that maps this painful trade-off between output and inflation.
To revert to the cricket analogy, batting on such a pitch is difficult.
Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.
