Economic dynamics necessitate re-prioritising policy targets

Updated: November 17, 2014 1:23 AM

Let’s educate our management students about this

About 30 years ago we economics fresh post-graduates had to go around trying to convince business school heads about the existence of a subject called ‘macroeconomics’ and its relevance to management education. Fortunately, the way things have turned out since, macroeconomics as a subject has taken centre-stage in all good management curricula. With incredible connectivity and access to technology, any intelligent student wants to make sense of the avalanche of information flooding in. Macroeconomics helps catapult the information into knowledge. Let’s consider the present nationwide call for interest rate cut by RBI.

Policy goals
Goals of macroeconomic policy are clearly stated as low unemployment, price stability and real GDP growth. The ‘social loss function’ assigns weightages to these goals while examining deviations of real rates from the target rates. For an overheated economy with high growth rate and double-digit inflation rate, inflation becomes top policy target. Given the inflation-growth trade-off, GDP is expected to slide, but that’s a calculated risk policy-makers must take. And if the economy moves into recession, with GDP growth rate down to 5% and inflation also down to 6%, target priorities must change so that growth and employment become top targets making inflation secondary. (In fact, RBI’s shift from WPI to CPI as inflation-anchor probably attempted to make its hawkish policy look dovish.) Target priorities decide if economic policy would be expansionary or contractionary. This precisely is the need in India at present and changing the policy targets to accommodate the economic dynamics should not hurt any policymaker’s ego nor suggest a defeated retreat.

Glide path
As I have argued in my earlier columns, the relative importance of targets must be mandated by the macroeconomic situation and not rigid obsessions. For this, policy-makers must draw up a glide path not just for inflation but also for growth rate and unemployment rate. And all deviations must be closely monitored and addressed in time to save millions of Indians pains of the ‘social loss’. These glide paths must have a lower gradient except in crisis. Maintaining a high gradient for inflation glide path would crash-land the economy by reducing growth and unemployment equally sharply. Rather, flatter glide paths would soft-land the economy.

Monetary policy must accommodate fiscal
In India, fiscal policy and government plays a greater role than the monetary policy which has limitations in its transmission. Inflation happened and continued due to non-monetary factors such as supply shortages, hoarding, crude oil price deregulation, supply chain bottlenecks, ‘policy paralysis’ etc. It has also come down due to non-monetary factors such as crashing global commodity and oil prices, better monsoon and domestic supplies, single-window clearance of projects cap on incremental MSP etc. Neither the responsibility of reducing present inflation was RBI’s, nor does the credit of the recently-reduced inflation go to RBI. If anything will spur growth and create jobs it will be removal of bureaucratic logjams and red-tapism, better governance, political stability, global factors and proactive economic policies.

Their power is limited
The RBI governor said he doubts if his lowering repo rate would revive the investment cycle by itself. He is very right. Monetary policy in India doesn’t have the power needed to lift the real economy out of a recession. It’s the government which can do so, and the monetary authority must just play along. Then how come RBI’s raising rates reduced growth? Well, raising rates continuously for 13 times and status-quo when reduction was needed, did raise the cost of funds vis-a-vis RoI rendering some projects unviable and signalled to investors that they were not welcome to borrow. Again, policy rates didn’t always transmit into market rates and even if they did, costlier finances were only one of the reasons pushing the economy into recession. Monetary policy by itself did not have the power to harm India’s real economy. Similarly Raghuram Rajan is right, his lowering rates may not ensure revival. But it will reduce one hurdle in investors’ way and more importantly, send a welcome signal to the economic entities.

Impossible trinity
The trilemma in macroeconomics says that out of the three goals: free capital flow; fixed exchange rate and independent monetary policy, a central bank can pursue only two simultaneously. With full current account convertibility and partial capital account convertibility, India has free cross-border capital flows. Our exchange rate, though flexible, is kept range-bound by central bank intervention and is on a managed float if not ‘fixed’. Thus going by the impossible trinity, we cannot have a completely sovereign monetary policy which is independent of actions taken by other central banks.

With Japan and eurozone going for massive quantitative easing after the US, there is going to be expansion in the monetary base around the world with falling or fallen interest rates. India at this hour cannot tighten money supply beyond a limit which would raise market rates pulling in foreign funds through carry trade, propping up the rupee superficially. Either the rupee would keep appreciating or RBI would end up injecting rupees in buying the incoming dollar stream, thereby raising inflation fears unless they sterilise their operation. The overvalued rupee would in future go for a free fall when global economy revives and their interest rates rise reducing the arbitrage margin and reversing the ‘carry trade’. So, RBI might do well to change course before it’s further late. Let’s educate our management students about this!

By Shubhada Sabade

The author is faculty of economics and head of ‘SIMS Economics Think Tank’

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