Advice For Mr Jalan

Updated: Oct 26 2002, 05:30am hrs
With the monetary and credit policy, 2002-2003, expected within a week, market participants and financial press have already begun speculating about the intent and actions of Dr Bimal Jalan. As in the past, the discussions seem to be on the theme of interest rates and growth. The general belief that monetary policy actions get transmitted to the real system through their effect on interest rates is the primary reason for this.

For the monetary policy to influence the real growth, however, it needs to control not only the short-term but also the long-term interest rates, for it is the latter that are expected to affect aggregate demand more significantly. To understand the way the Reserve Bank (RBI) can potentially set the term structure of interest rates and the sustainability of a low interest rate regime, we need to analyse the factors that determine interest rates both at the short and long end, and the RBIs ability to control these factors.

The last couple of years have witnessed a significant downward shift in the entire term structure of interest rates; the average of 3-month and 10-year interest rates during the last fiscal year is about 350 basis points lower than that of the previous three years. And the ratio of volatility of long rates to short rates has gone up from 0.56 to 1.27 during this phase.

While the decline in short rates can be attributed to the prevailing liquidity conditions in the system, they cannot explain the fall in the long rates as the latter are driven by the expected real rates of return and inflation over the long run. The fall in longer-term yields have to be attributed, therefore, either to a decline in expected real rates of return or expected inflation rates.

The real rate of return or interest over a longer term is primarily determined by the productivity of capital employed and hence, the expected real growth of the economy. If the real rate of growth of the system is expected to be high, one could expect the real rate of interest to be high. For this reason, it is safer to assume that the level of longer-term real interest rate is not a policy variable that can be controlled easily. One should note that standard (Keynesian) argument that lower interest rates will induce higher investment and growth is essentially a short-run argument and assumes availability of significant excess capacities in the system, and is not suitable for analysing the determinants of long-run real interest rates.

If long-term real interest rates are assumed to be relatively stable, the decline in long-term yields could be attributed, as is generally believed in the market, to a fall in inflation expectations and expected short-term interest rates. There are two problems with this explanation: (i) how to reconcile burgeoning fiscal deficits with falling inflation expectations, and (ii) if the fall in longer-term yields is due to moderated inflationary expectations because of credible policies of RBI, it should lead to a fall, and not rise, in the longer-term interest rate volatility.

There is an alternative explanation: the lack of growth opportunities seem to have led to a decline in demand for funds from the private sector, in turn exerting a downward pressure on interest rates despite high fiscal deficits. Contrary to general belief, the causation between growth and interest rates seems to be reverse. It is the low growth that is sustaining lower levels of interest rates rather than lower interest rates inducing high growth. Hence, the observed low levels of long-term interest rates may not reflect moderation of agents inflationary expectations. From this standpoint, the excess volatility of interest rates reflects the uncertainty related to the growth process and the credibility of the central banks policies.

The implication is that the monetary authority must recognise that its ability to maintain interest rates at low levels is at best limited, unless the fiscal deficits are contained or private demand for funds remains low. The forthcoming monetary policy statement must explicitly recognise some of these aspects in laying down a vision statement about optimal and sustainable interest rates.

The author is a consultant with the National Stock Exchange. Views expressed are personal. E-mail: