by Ila Patnaik, Indian Express 4/1/11
The Indian economy is showing signs of overheating. But the RBI lacks a clear monetary policy framework that can address the problem. In the coming years, the RBI should focus on research that will build the foundations of such a framework.
The performance of the Indian economy in 2010 was beyond expectations. The GDP growth was higher than expected. But at the same time, inflation was also above acceptable levels. The current account deficit was higher than historical levels. Property prices rose at an average of 30 per cent during the year. Liquidity became tight and credit demand rose. By the end of the year the Indian economy witnessed most signs of overheating.
However, concerns about output and employment growth weighed upon policy-makers. There was no serious attempt at fiscal consolidation. Monetary tightening neither pulled output growth down nor contained inflation. Did India err on the side of too much caution? Should macroeconomic policy have been tightened much more to prevent overheating?
Macroeconomic policy-making is hard, as it involves judgment and is done under conditions of uncertainty. Raising rates is also almost always harder than cutting them. Few people criticised Greenspan’s low interest rates or clamoured for hikes in the Greenspan years. The “great moderation”, with low inflation and stable growth, was appreciated by most at the time.
India is one of the fastest growing economies in the world today. It is an engine of growth for the world economy. High growth rates in India are above expectations and almost unbelievable. A rate hike that would upset growth would be unpopular.
Further, to have a significant impact on growth and inflation, the RBI would have to raise rates significantly. Monetary policy transmission is weak in most emerging economies. Financial markets are not well developed, and changes in policy rates do not translate into changes in lending and borrowing rates across the financial sector. In addition, a large part of the economy only has access to informal finance. This makes the transmission mechanism of monetary policy in India very weak. Former RBI governor C. Rangarajan had to raise rates by 500 basis points to bring high inflation under control. Small changes in rates do not have a large enough impact on the economy. Weak transmission of monetary policy makes the central banker’s job even more difficult. That we do not know how weak this effect is, makes the problem harder.
Monetary tightening would perhaps be less unpopular if it was happening in the midst of high export growth. If the RBI raises rates, interest differentials with the world would increase. Fears of carry trade and rupee appreciation would be raised. Concerns about the sustainability of the current account deficit would be raised. What would be forgotten is that the most important determinant of export and import growth is growth in the world and Indian economies respectively. A reduction in Indian GDP growth would reduce the demand for imports. A reduction in domestic prices would shift demand away from foreign goods to domestic goods. Lower import growth would reduce the current account deficit. Any effect of rupee appreciation on trade is likely to be small compared with the effect of a change in output. A large current account deficit, a symptom of high aggregate demand, is normally a reason for raising rates, not keeping them low. Empirical studies of the causal relationships involved are needed to assess the magnitude of the impact.
In addition, food inflation accounts for a significant share of India’s rising inflation. Our understanding of the role of monetary policy in India in stemming inflation when food prices rise is still rudimentary. Little theoretical or empirical work exists to support the view that the RBI can do much to control inflation when it is caused by rises in the price of food. While there is some recent evidence to suggest that food inflation feeds into higher wages and higher inflationary expectations, setting off a wage-price spiral, there seems to be little consensus within the RBI to support this view. Speeches by RBI staff often take a different and conflicting view on the subject. An understanding of inflation caused by rising commodity prices is similar. There is confusion within the RBI about whether it should respond to rising world commodity prices by raising rates or not.
The consequence of the RBI’s lack of research and a clear framework was visible in the most recent credit policy review. When its policy of monetary tightening failed to slow down growth or inflation, and the money market continued to witness tight liquidity, the RBI put brakes on its policy direction, and signalled monetary easing. This happened to be exactly the opposite of what it should have done.
Looking forward, the RBI may raise rates, but its lack of conviction may mean this might be done in baby steps and may have little impact. High inflation may consequently become a problem that remains with us for many years.
This lack of both clarity and framework, on the part of the RBI, has resulted in one of India’s biggest problems: high inflation. Empirical and theoretical research to understand price behaviour and the functioning of monetary policy in India; how policy should respond to food inflation and commodity prices; inflationary expectations; what would be the impact of changes in policy rate on output, on prices, on the rupee, and on the current account deficit should be on top of the RBI’s agenda.
Instead of engaging in debates about whether inflation should be one of its many targets, or its only target, the RBI should focus on building a monetary policy framework that helps India obtain a low and stable inflation rate. A country with high inflation can neither guarantee financial stability, not high growth or employment. Only when RBI has a clear, coherent and effective strategy, backed by high quality empirical and theoretical research, on how to tackle inflation, can it fulfil its primary role and function. Research to develop such a framework should be the RBI’s top priority in 2011.
The writer is a professor at the National Institute of Public Finance and Policy, Delhi