Some RBI dos and don'ts

Indian Express, 18th September 2013

It should slash interest rates, stop worrying about inflation or the rupee.

A few weeks ago, in a measure described as temporary, the RBI raised interest rates and tightened liquidity to defend the rupee. Today, interest rates are up to 400 basis points higher than they were in July. These should be reduced immediately, before they are transmitted to higher bank lending rates. That would mean a reversal of the RBI's measures.

Once the short-term steps are reversed, there can be a discussion on monetary policy and on whether the repo rate should be changed. The first argument for cutting rates is forecasts of lower non-food inflation. Demand conditions in the domestic economy are weakening. Not only have consumer and investment demand slumped sharply, the latest quarterly expenditure-based GDP data indicates a demand contraction. It shows a decline of 8.2 per cent in seasonally adjusted private final consumption expenditure, and of 14.2 per cent in gross fixed capital formation. The quality of this data is suspect, so we corroborate it with firm-level data, which also shows a sharp fall in new investment activity. All this points towards a lower non-food inflation forecast, because of declining demand.

However, it may be argued that there could be inflation due to an exchange rate depreciation. One measure of tradeables inflation is the US producer price index multiplied by the rupee-dollar exchange rate. This measure takes into account commodity prices, raw materials for industry, price of output when it can be exported or imported, as well as the exchange rate. Since commodity price inflation is low, it shows that even after including the most recent depreciation, tradeables inflation has fallen sharply. The trend suggests that in coming months, inflation is unlikely to rise significantly because of import inflation.

Most central banks, including the RBI, look at a measure of core inflation to forecast consumer price inflation. It is a measure that captures demand conditions in the economy. Core inflation excludes the most volatile part of inflation, caused by transitory factors that must be excluded while making inflation forecasts. In recent months, core inflation, whether measured by the non-food, non-fuel WPI or the non-food WPI, has declined to below 3 per cent. It has been below 5 per cent for most of 2013, creating confidence that this is not simply a one-off phenomenon. We usually see high persistence in this measure of inflation. It therefore suggests that core inflation is likely to remain low.

The second element in a discussion on the choice of monetary policy is the output gap. While there appears to be a decline in India's potential output, the actual fall in output appears to be much larger. This indicates that there is an increase in the output gap. An increase in demand can expand output even without an increase in capacity. This increase in demand can come from external or internal sources. In our case, there is not much of a case for fiscal expansion, since the deficit is already high and its increase can lead to other difficulties, such as a fall in the country's credit rating. Monetary easing can, however, help increase demand by households and firms.

An additional impact of monetary easing is currency depreciation, which can help increase demand for tradeables. Despite the recent data showing an improvement in exports, there remains a lot of pessimism about the price elasticity of tradeables, both exports and imports, in India today. While it may be true that in the short run the price elasticity of exports and imports is often low, it is rarely zero, and is clearly not positive. A depreciation serves the same purpose as an import duty combined with an export subsidy. As most people will agree, an import duty raises the price of imported goods. A depreciation also does this, across the board and without government interference or an army of customs officers, and without the smuggling and illegality that high duties often bring.

India is now seeing one of the worse declines in production and output. Regardless of the time that an exchange rate change will take to create an adjustment in the current account, the direction needs to be towards a weaker currency. If there existed measures of the real exchange rate which would help identify the precise long-run equilibrium, then at the present stage of the cycle, a weaker currency should be preferred for its expansionary impact.

We finally turn to the question of credibility of the central bank. Since 2008, the RBI has allowed the rupee to float and followed an independent monetary policy. It raised rates, even while the US lowered theirs, in response to domestic business cycle conditions, which then showed that inflation forecasts were higher than its targeted levels. While there was no specific inflation target, and the RBI sometimes made confused speeches about it, there was a shift towards indicating that inflation control was gaining superiority over exchange-rate targeting as the objective of monetary policy.

Earlier this year, in pursuit of monetary policy independence, within the constraints of the trilemma, the RBI indicated that its forecast for inflation and output gap now warranted a cut in interest rates. This was done even though there was a very high likelihood of interest rates rising in the US. The implication was that the RBI, by floating the exchange rate, had now created the space for a monetary policy that could respond to domestic business cycles. The fact that it failed to explicitly state the target, the measure and give up its other objectives appears to have come back to haunt it now. But when Ben Bernanke indicated that he would taper QE, the RBI appears to have lost its nerve. It tightened monetary policy in a needless defence of the rupee and not because domestic business cycle conditions warranted it. But one saving grace was that it was emphasised that the increase in marginal standing facility rates and tightening of borrowing rules on liquidity adjustment facility were only temporary. Undoing these and going back to the path of monetary easing would not undermine the RBI's credibility, but add to it.

The floating exchange rate has worked well for India from 2007 till now. In downturns, the rupee depreciates, and in good times, it appreciates. If we stay on course, the objective of monetary policy will be clear and consistent. In contrast, going back towards an exchange rate policy will raise a whole new set of uncertainties and hurt investment.

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