A broad array of economists would forecast inflation in India to register values of zero or slightly negative values in 2009. As a consequence, the short-term interest rate (the rate on 90-day treasury bills) of 4.5% that prevails today works out to a real rate of 4% to 6%. This is a highly restrictive monetary policy stance, one that is out of line with the state of the economy. Another analytical googly: RBI has said, in an almost offhand way, that it is targeting CPI, and not WPI. Such a major change in the monetary policy mechanisms, if it has really taken place, cannot be dealt with in such an offhand manner. In well-functioning policy set-ups, the ministry of finance gives the central bank an instruction about which inflation measure to target. A substantial effort of research and communication needs to take place if RBI has switched from focusing on WPI to focusing on CPI. Almost passing remarks on such a subject, as in the credit policy statement, are grossly inadequate.
Changing the game
The credit policy, it seems, has failed to come to grips with the real problem. Monetary policy is not an end in itself. That is, modifying the short-term interest rate for riskless borrowing in the economy is not important per se. The real power of monetary policy lies in its ability to influence the cost of equity and debt capital for myriad individuals and firms all across the economy. If monetary policy can do this, then it is useful and can contribute to alleviating a downturn. If monetary policy cannot do this, then changing the short-term interest rate doesnt alter the game at all. Of course, the first-order problem is the lack of monetary policy transmission. RBI has done well in cutting rates at the short-end of the yield curve from October 2008 onwards. But these changes have clearly not propagated into a reduced cost of equity and debt capital all across the economy.
Now, theoretically there are two ways of looking at this from the policy level. The ideal way is to start addressing the systemic reason why plentiful raw materialcheap money at the short endis not translating into cheaper equity and debt capital all across the economy. This kind of approach will worry about questions like why changes in the short rate make no difference to stock prices. The answer: banks are largely walled off from giving loans against shares. It will also take the broad contours of financial reform and apply them to banking, bond markets, derivatives and futures, etc. But assuming Dr Subbaraos plan of action is more limited in scope, he still must recognise that if RBI is to matter at all in alleviating this downturn, the institution must be a game-changer now, when forecasts of future inflation and aggregate demand are pointing south. These columns had argued for a sharp cut in policy rates precisely for this reason. They had also pointed to the lack of competition among financial firms. What do we have as the effect of monetary policy right nowan irrelevant game where the price at which banks lend to each other on the call money market is modified, and nobody else is affected; where banks treasury operations on government securities are earning them profits and nobody else is benefiting from easy money. True, RBI doesnt have to wait for scheduled policy reviews to cut rates. But whats the point of scheduled policy reviews in these critical times if the central bank cant get its analytical and policy approach right