Moving from the textbook to reality, we have seen that when the market expects RBI to increase rates by 25 bps, and RBI does so, then nothing changes. This means that if RBI goes by the script and makes changes only in the eight policies then the changes will not matter. Taking the theory forward, Lucas would say that only surprise monetary action works. But, not for too long as the markets discover the same and then revert to their equilibrium.
The second is that if we can expect changes on eight occasions, then will there still be surprises in between. Here, RBI has played safe and said that it would retain the prerogative to intervene in case the situation demands. In such a case, it means that there can still be surprises before September 16. But such an intervention should only be rare or else the purpose of having eight reviews would become superfluous.
The third is that the market is quite touchy and is always on the look out for signals to the extent of finding them where they do not exist. Therefore, whenever RBI officials make a statement in any seminar or outside a seminar, they run the risk of being quoted or quoted out of context, which, in turn, can spook the markets. A RBI official stating that inflation is a major concern can be interpreted as impending action on interest rates. Hence, even if RBI sticks to the eight-policies rule, and does not spring surprises, the market will be monitoring the words of RBI in every forum to pick up signals, which cannot be avoided.
This is significant because today RBI has a problem in so far as that the market is forever guessing what it is going to do, when it will do and what it wants to do. If it does nothing till the policy, then it becomes predictable and may not matter as they buffer in such changes. For monetary policy to be effective, the desired results must accrue. If rates are increased, all interest rates must go up or else the measure falls flat. Hence, if RBI has focused on demand-pull inflation, then when the repo rate is increased, lending rates must also rise. If not, then the purpose will not be achieved and we will end up saying that monetary policy could not control inflation. This leads to another issue of whether the policy change has to be substantially large to actually make a difference. Or alternatively, there has to be a surprise element and the quantum of change must be substantial to be effective.
Today, all central banks meet oftenthe Federal Reserve had eight meetings while the Bank of England and Bank of Japan meet every month to provide a view on the monetary sector. The ECB meets twice a month, though admittedly only the first is meant to discuss monetary policy. Hence, such fine-tuning is not really out of place in the global context; although changes in interest rates are of a lower frequency in general and there have been times when the central banks have announced monthly changes.
It may be recollected that we used to have two policies earlierslack and busy seasons, and these concepts were abandoned when it was realised that there were no slack and busy periods, and that we should have four policy reviews. Hence, a further multiple to eight looks in order. However, considering that the market appears to guess right each time what RBI will do, to be effective, there may be a strong case for arguing for more discretionary action to deliver so that the market is impacted.
In a theoretical sense, it will mean abrupt Keynesian fine-tuning within the rational expectations framework.
The author is the chief economist at CARE ratings. These are his personal views