Transmission impossible
Financial Express, 16 May 2008
The Raghuram Rajan committee on Financial Sector reforms has recommended that the RBI should focus on inflation, rather than other objectives. This recommendation has raised considerable controversy.
One counter-argument that is made is: RBI is already focused on inflation, so nothing needs to change. RBI governors and deputy governors are known to make rousing speeches about the importance, of inflation. But RBI has behaved in a manner which displays a profound disregard for inflation. All through the year RBI has cared foremost about pegging the rupee dollar rate, and did not care the about inflation that this could create.
Money supply growth accelerated from 15 per cent to above 20 per cent since the beginning of 2007. With GDP growth below 10 per cent, it is not surprising that inflation accelerated. To put it rather simplistically, if GDP is expected to grow at 10 percent and we tolerate a rate of inflation of 5 percent, then if money supply grows by much more than 15 percent, there will be pressure on prices to rise. It can be higher by a couple of percentage points as the economy is monetising, but not by a rate higher than that.
In thinking about RBI reform, it is interesting to ask: What would the behaviour of RBI have been if it was a central bank that cared about inflation?
The growth in money supply has come because of the RBI's very high net purchase of dollars to prevent rupee appreciation. If RBI had cared about inflation, it would have been reducing its purchases of dollars, and thus keeping down reserve money growth which grew at 31 percent last year. This would have had a clear impact on the growth of broad money supply or M3. A lower growth rate of money supply would have given lower inflation of non-tradeables. Today when the RBI discusses inflation it lays no blame on its currency policy and the conflicts an anti-inflationary policy has had with a liquidity pumping exchange rate policy. There is no mention of how the currency policy is incompatible with the goal of lower inflation. In international experience central bank reform has often come when the central bank has emphasised that it is unable to meet the low inflation expectations of agents in the economy because it is being saddled by other objectives. If low inflation is the focus of the central bank, the central bank tries to persuade policy makers to move away from policies that prevent it from efffctively pursuing this policy. We have not seen RBI do any such thing. On the contrary, it has been claiming that all is well and under control.
The recent bout of inflation has been blamed purely on global factors. Here too, if RBI had not been buying dollars, a rupee appreciation would have ensued. This would have made foreign goods cheaper. Imported goods such as food, fuel or metals would have been cheaper because the exchange rate would have been more favourable. This would have given a lower inflation for tradeables.
Put together, through these two channels, a central bank that cared about inflation would have behaved very differently from RBI in the last few years, and delivered lower inflation as a consequence. All countries in the world are exposed to this difficult global environment with high commodity prices. But we have done worse than countries where a proper monetary policy framework has been put in, in terms of the inflationary consequences.
The third area where RBI reforms would yield a fundamental change in behaviour lies in financial sector reforms. At present, RBI uses its institutional might in preventing the development of the currency market and the bond market. Sophistication in these markets is feared by RBI because it will lead to a loss of control by RBI of the exchange rate and of interest rates.
This is not how monetary policy is best implemented. A central feature of monetary policy functioning is the "monetary policy transmission". The central bank makes small changes to the policy rate, and this affects interest rates across the entire economy through the functioning of the bond market and the currency market. A sophisticated `Bond-Currency-Derivatives Nexus' is the essential tool through which a central bank achieves the power of influencing inflation.
When inflationary pressures arise, the central bank changes the policy rate by a small amount, and the Bond-Currency-Derivatives Nexus does the rest of the work by influencing interest rates all across the economy. If RBI had cared about inflation, it would have supported the reforms required to build the Bond-Currency-Derivatives Nexus. Instead, what we saw was an RBI that cared about pegging the exchange rate, and used its power to ensure that India does not have a bond market and a currency market.
In summary, what is the meaning of RBI reforms aimed at refocusing monetary policy on inflation? Three clear areas of differences are visible. RBI would not have bought dollars on a massive scale from 2005 onwards. Through this, the prices of tradeables and non-tradeables would be lower today. And, RBI would have stepped out of the way and promoted the development of the Bond-Currency-Derivatives Nexus, which is the monetary policy transmission through which inflation can be kept in check.
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