Managing expectations
- Ila Patnaik
Financial Express, April 29, 2006
Dr Reddy got a lot of praise when he did not raise rates in Credit
Policy 2006-07. Ironically, the credit policy statement is full of
indications that RBI perceives inflationary expectations to be
high. This view on future inflation appears inconsistent with the
decision to keep rates unchanged. Saying that RBI will keep a watch on
inflation, and act when the need arises will confuse the public and is
not the best way to manage expectations and conduct monetary policy.
Most of us do not run models to forecast inflation. But we believe
central banks do. If inflationary expectations were actually low
before the credit policy announcement, there are few who would not
have revised their opinion after reading the policy statement. RBI has
made a convincing case for expecting higher inflation. The impact of
higher world oil prices has not seen a complete pass through to
domestic prices in India, but it has to happen. There may not be
clarity on when the inflation rate will go up, but after reading the
statement one comes away with the distinct feeling that inflation
rates are on their way up.
Life is not easy for central bankers. Based on a variable that is not
observed -- inflationary expectations -- they have to use instruments
like interest rates that are known to impact inflation after about at
least a year and a half. RBI has to choose from a number of
instruments available to it -- the Cash Reserve Ratio, the bank rate
and the repo rate. Moreover, it has to use flawed measures of
inflation rates, whether based on WPI or CPI, whose data is collected
by other agencies and which do not offer a clear picture for decision
making. The Government of India has further burdened the RBI by
imposing upon it the tasks of public debt management, currency
management and banking regulation, which often have conflicts with the
conduct of monetary policy.
However, despite the difficulties, in recent times central bankers
have been increasingly successful in the conduct of monetary policy by
managing expectations. For example, when Alan Greenspan felt that
inflation in the US was rising and interest rates should go up, he
made many speeches saying so and then followed them by raising
rates. The Bank of England has managed expectations by setting up a
transparent mechanism -- the Monetary Policy Committee -- which is
given an inflation target and which puts up the minutes of its
meetings on its website. This allows people to know why certain
decisions are being taken and to know what to expect.
Why is it important to manage expectations? Primarly because the
effectiveness of monetary policy depends on what the private sector
expects from it. The research on rules vs discretion, credibility and
time consistent policies, inflation targeting and Taylor rule, all
agree on one thing. That the private sector factors in what it
believes is the central bank's policy and that makes all the
difference to the impact of central bank policies. When households and
firms make decisions, the outcomes are much better when interest rates
move as expected. The credibility of the central bank is of utmost
importance. Private agents form expectations and make decisions based
on what rules, explicit or implicit, they expect the central bank to
follow.
Credit policy 2006-07 leaves Dr Reddy with a difficult task. His
policy document makes it very clear that inflationary expectations are
high. Yet, he did not hike rates. As a consequence, people can no
longer expect that if the RBI perceives inflation to go up, it will
hike rates. Listening to the RBI for the last few months had created
expectations that rates would go up. Even one hour before the policy
there was confusion -- half the analysts on TV were saying rates would
go up, the other half were hoping they would not.
What should be done now? The internal decision to raise or not raise
rates in July (or before that) should not be left until then. Within
the RBI it should be made now. Then, if he is going to raise rates, Dr
Reddy should say so, and keep saying so again and again till people
are sure that he will, and then come July, he should raise them.
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