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

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