Watch like a hawk

Indian Express, 21 September 2011

Raising interest rates when growth is slowing down would not have been an easy decision to make for Reserve Bank Governor D Subbarao. However, despite the unpopularity of his stance, he did not take a short term view of the problem. He did not respond to the clamour for no further raising of interest rates. This was the right thing to do.

The most important argument against the rate hike is that there are indications that the economy will slow down to below 8 percent GDP growth. And so, it is argued, that as a central bank that looks at growth and inflation, the RBI should, therefore, not raise interest rates. One of the main reasons why central banks in countries that try to achieve macroeconomic stabilisation, have moved to inflation targeting is the evidence that there is no trade-off between growth and inflation. The notion that there is a Phillips Curve, or such a trade-off, rests on the belief that there is no role for changing expectations about inflation. Monetary policy in the US in the sixties that rested on the notion of the trade-off ended up easing monetary policy in periods of low growth. The net result was a long period of low growth and high inflation. This stagflation was addressed only later when the role of monetary policy was understood better.

One of the major elements of this new understanding and consequent framework of monetary policy was the role of inflationary expectations. For example, economic agents repond not merely to the inflation rate today, but to what they expect the inflation rate to be in the future. Wage contracts and product prices both involve calculations about future prices. To take a very simple illustration, if workers expect higher costs of living, they accept a wage contract that takes this into account. If producers have to pay higher wages and input costs, they accept purchase orders at higher prices. So if costs of production are expected to increase, it leads to cost push inflation, without there being an actual increase in costs. Unless inflationary expectations come down, there will be expectation of higher prices, and inflation would continue to be high.

In this setting, the role of the central bank is not seen as merely raising or lowering the cost of borrowing, it is a much bigger role. It is the role of managing inflationary expectations. If the mandate, the communication, credibiliy building strategies such as those of transparency and accountability of the central bank are able to convey to the public that inflation in the future will be low, the push to prices coming from higher expectations can be taken care of. In this framework the central bank's job is not merely to raise or lower the interest rates. It has to communicate to the population that it will control inflation. It has to do this with credibility, that it will need to build over time. This job is difficult in any setting, but it is even harder in a developing economy where the central bank does not have the mandate to target inflation and the systems of accountability that would make it credible do not exist. Without these elements in its monetary policy strategy, the central bank will impose the pain of higher rates, but not get the benefits of reducing inflationary expectations.

Monetary policy in India has been located in the pre-1970s macroeconomic framework when it was believed that you could achieve higher growth with higher inflation. Even now when mainstream macroeconomic thinking in the world has moved away from this belief, one still hears these arguments in public debates. To some extent, the rate hike seen last week is an element of modern monetary policy thinking. Even though we observe some slowdown in growth, there has been no let up in monetary tightening since inflationary expectations remain high. Had the slowdown been enough to pull down expected inflation, RBI would not have needed to raise rates. RBI's fight against inflation now needs to be taken to a new level where it builds up the institutions that allow it to implement this strategy fully and properly.

Higher interest rates impose costs. Industry has to pay more as interest. Anyone holding a mortgage pays more. Banks usually do not do well in a period of rising rates. Old loans are at lower rates, and in the transition, business becomes unprofitable. Also, overall demand for the business of loans slows down. This cost creates protests against tightening of monetary policy as seen in the reaction to the latest hike.

The coming years could witness high macroeconomic instability. There is uncertainty in the world economy, a policy paralysis in the Indian government, the lack of decision making by bureaucrats and politicians on various stalled projects and the corruption scandals in India. High inflation could cause further macroeconomic instability. It is thus important to ensure a low and stable inflation rate.

Is it time for the RBI to pause? The answer lies in whether the expected slowdown in growth is enough to persuade people to expect lower inflation. With some commentators talking about settling for a higher "normal" rate, and others suggesting that the RBI should focus on making sure growth does not decline, it does not appear that anyone is convinced that the problem of inflation in India has been solved. This makes it a very dangerous time for RBI to pause on the tightening. If the option is to tighten more and prevent a long and protracted phase of high inflation, future rate hikes may need to be even higher. The RBI will need to watch inflation like a hawk.

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