India in depth: Changing recipe of monetary sauce

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In question: Monetary policy of India's central bank In question: Monetary policy of India's central bank

The Reserve Bank of India's in-house rule for setting interest rates is a secret sauce in desperate need of a new recipe.

The ingredients for the rate-setting formula are not known. But a Breakingviews examination of India's call-money rates, inflation and GDP over the past 13 years shows that the central bank has historically placed a rather low emphasis on taming inflation, while fretting more about output slumps and currency swings.

The danger of such an algorithm is plain to see. While the government's fiscal recklessness deservedly shares the blame for India's stagflation, monetary ineptitude is equally responsible for hobbling the once fast-growing economy.

That is about to change. Raghuram Rajan, the RBI's new governor, unexpectedly raised the policy rate in September, giving a strong hint that the central bank is turning into an inflation hawk. He also set up a panel to recommend a fresh monetary strategy that is more "predictable and transparent."

The central bank needn't become a completely open book. But a more robust response to inflation is a welcome break from the past. A monetary policy rule that targets several variables risks falling between stools. That's the case now. Inflation is almost at double-digit levels but the economy, which grew just 4.4 percent in the June quarter, is operating below capacity. The paradox is partly explained by the RBI's actions. The central bank's target short-term interest rate has in the past responded three times more forcefully to an output shortfall than to higher inflation.

Such a policy rule can work without any major hiccups for a long time, but it has a corrosive effect on behaviour. Even in the event of hyperinflation, savers can't expect the central bank to come to their rescue. Fearing erosion of their savings, they add gold and real estate to their portfolios. Fiscal overreach makes things worse. Elevated government deficits absorb a bulk of dwindling financial savings, pushing interest rates higher than they would otherwise have been. That blunts the impact of monetary policy. Growth plummets, but inflation stays high. A stagflation-type crisis erupts.

That's not all. In the past, the RBI has also demonstrated an unhealthy obsession with the exchange rate. When the rupee was appreciating against the U.S. dollar before the 2008 financial crisis, the central bank had a tendency to set short-term rates lower than they should have been. Its motivation was to prevent the economy from being swamped by yield-chasing capital inflows.

The concern now is the opposite. The rupee has tanked because of investors' misgivings about India's bloated trade deficit. In July, the RBI raised short-term interest rates by 3 percentage points to prevent capital outflows, showing once again that it cared less about the currency's domestic purchasing power than its value in overseas transactions.

Rajan is now dismantling his predecessor's ill-conceived defence of the currency. In this, he has been lucky. The rupee is stable at about 62 to the dollar. But danger lurks. Nobody quite knows how the central bank will respond if expectations that the U.S. Federal Reserve will soon start withdrawing excess dollar liquidity resurface, putting the rupee under renewed selling pressure.

Yet Rajan's goal must be to tone down the importance monetary policy assigns to variables other than inflation. Exporters become complacent because they know that the monetary authority tends to fight currency appreciation. A good example is the Indian software industry. It has been wildly successful because of the country's cheap labour, but has underinvested in research, and is struggling now to develop its own intellectual property. Similarly, knowing that the central bank will cut interest rates to keep output at an even keel absolves the government of its responsibility to boost the capacity of the economy.

India's hotchpotch monetary rule has also failed to anchor inflation expectations. Even with GDP growth at a 10-year low, surveys show people expect prices to keep galloping. If citizens were confident that the central bank would bring inflation down because that's what it always does, then some of that faith would show up as lower inflation today.

Looking at inflation, Breakingviews' analysis of past RBI behaviour suggests overnight rates should be around 8.4 percent. The central bank's determination to shore up the currency would add 0.9 percentage point to the theoretical number, while its desire to reduce the output gap would reduce it by 0.6 percentage points. Combine the three ingredients, and the final rate - based on historical trends - should be 8.7 percent for the third quarter of 2013.

But following Rajan's intervention, the actual rate was 9.5 percent on Sept. 25. Since Rajan's actions suggest he cares less about the value of the rupee and lost output, the higher observed rate points to one explanation: banks believe the new governor is putting a greater emphasis on controlling inflation than before.

This new rule, if Rajan can make it credible, could lead India to embrace a formal inflation-targeting regime. But it shouldn't be in a hurry to go down that route. Since the 1997 financial crisis, most developing countries in Asia have adopted arrangements whereby the central bank is given an inflation goal by the government or parliament, and told to focus its efforts on achieving it. By and large, inflation targeting has worked -- but not everywhere, and not always. For example, the Bank of Thailand steadily raised interest rates in 2006 in an attempt to rein in inflation. The hot money that poured eventually prompted the country to impose capital controls. Thai assets were subsequently walloped.

Before India can migrate to inflation targeting, the government must first prune its permanently elevated budget deficit, so that it's able to use fiscal policy to dial economic output up and down. Still, there is no doubt that too many ingredients are spoiling the consistency of India's monetary broth. Even if Rajan can't adopt a simpler recipe overnight, he can enhance the anti-inflation flavour of his interest-rate concoction.

Andy Mukherjee

The author is a columinst currently writing for Reuters' Breakingviews

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