China just reduced interest rates by 25 basis points, the first reduction since 2008. Australia has reduced its interest rates twice in the last month by a cumulative 75 basis points. These decisions have been applauded by all, governments, investors and analysts. RBI reduced interest rates by 50 basis points near the end of April and most analysts (especially those belonging to foreign banks) were severely critical of the RBI decision. Why this asymmetrical treatment? Sometimes I half-believe in conspiracy theories interested in keeping Indian growth down so that Indian governments will be less arrogant!
More seriously, the setting of interest rates is a complex issue, and especially so now. Monetary policy can no longer be assessed in isolation. In the old closed economy world, one looked at domestic money supply growth to draw almost any inference about monetary policy. There was a level of such growth that was assumed to be ?right? and departures above it had to be reined in, and departures below meant more money needed to be supplied. Of course, as Keynes rightly pointed out, this strict and ancient monetarist model had a deep flaw?it assumed the velocity of money to be constant and insensitive to the level, and changes, in interest rates. That world has long passed.
In the new world, most subscribe to the Taylor rule, provided by John Taylor who very well might be the next FED chairman if Mr Romney wins the November election. The rule essentially stipulates how much a central bank should change the nominal interest rate as inflation, output and other economic conditions change. In essence, the rule demands that monetary policy become tighter when inflation (and/or growth) is higher than ?targeted?, and looser when inflation (and/or growth) is less than targeted. However, in an increasingly globalised world, economies are rocked by other developments, e.g. exchange rate movements. Therefore, the setting of short-term policy rates, especially in emerging economies like India, cannot be solely dependent on output and inflation gaps?the real exchange rate gap is therefore included in the augmented version of the Taylor rule.
Application of the Taylor rule helps to settle the question of whether a central bank is ?behind the curve?. The origins of this phrase pertain to the normal bell-shaped curve; the left half is ?behind? the median, and that is a ?bad?; the right side is ahead of the pack, or certainly ahead of the rest, and therefore is ?good?. If policy interest rates are lower than what they should be, then the central bank is behind the curve. Not well acknowledged is the fact that a central bank is also behind the curve when interest rates are higher than they should be.
The Taylor model yields a predicted value for the repo rate, which indicates where the rate should be. The repo gap (difference between actual and predicted) contains information about whether the central bank is ?behind the curve?, a negative gap, or ?ahead of the curve?, a positive gap. A priori, it is not clear whether a positive gap is good, and a negative gap, ugly.
The Taylor rule has been applied to 26 countries, 17 developing and 9 developed economies, on the basis of quarterly data since 2002. (Details are available in Developing Trends?Central Banks: The Good, the Bad and the Ugly, Nov 2011, http://www.oxusinvestments.com). Calculation of the Taylor rule for India for the current April to June quarter can illustrate its workings. The ?neutral? repo rate for India for the post 2009 period is 5.9 percentage points, i.e. if growth, inflation and the real exchange rate are at targeted trend levels, then the repo rate in India should be 5.9%. Now, each 1 percentage point increase in growth, and inflation, above ?trend? or ?targeted? levels causes the predicted repo rate to increase by 19 and 10 basis points, respectively. Each 10% decrease in the real exchange rate (a real devaluation) causes the predicted rate to increase by 4 basis points. All analysis is done on the basis of data lagged one quarter, which is appropriate since policymakers do not have current information when they set policy.
During January-March 2012, year-on-year industrial production growth in India averaged 0.6%, compared to a trend rate of 6%. In the same period, CPI Inflation (new index) averaged 8.6% while a weighted average of old indices averaged 6.5%. While high, this new CPI inflation was still below average CPI inflation of 10.2% since 2008! The real exchange rate averaged around its long-run value of 99 in both September-December 2011 and January-March 2012.
Assuming targeted industrial production growth of 6%, and targeted inflation of 7%, the Taylor rule yields the result that the repo rate should decrease by 80 basis points from its neutral value of 5.9%?a 100 basis points decline because of very slow industrial growth, and a 20 basis points increase because of higher inflation. Thus the appropriate Taylor rule rate for India at present should be 5.1%.
RBI reduced repo rates, from 8.5-8%, in April 2012. This only very partially filled the very large behind-the-curve gap of 280 basis points. Even an additional 50 basis points cut on June 18 would still leave RBI, and the economy, gasping for breath. The average gap in repo rates starting 2011 for developed economies was zero; the average gap for developing economies was 37 basis points. For India, the excess repo rate since January 2011 has been close to 200 basis points, the highest in the developing world. A catch-up of at least 250 basis points from here would still be required to get RBI, and hopefully the economy, into neutral territory or at par with the rest of the developing world. Therefore, a rate cut of 50 basis points on June 18, followed by several more rate cuts, is something dictated by logic, analysis, and the Taylor rule. Any other recommendation is likely not based on an objective model, and likely based on ideology, or personal biases of the kind ?Don?t confuse me with facts?my mind is made up?.
The author is chairman of Oxus Investments, an emerging market advisory firm. Please visit http://www.oxusinvestments.com for an archive of articles etc; surjit.bhalla@oxusinvestments.com