The curious thing about monetary policy is that it should be unpredictable to be effective
RBI has a flair for introducing new terms in our economics lexicon. The concept of ‘protein inflation’ was quite novel as was the concept of ‘calibrated movements’ in interest rates. The latest is the ‘glide path’ of inflation as per the new approach of inflation-targeting. Now that we are almost there with CPI inflation being less than 6%, which was the terminal point of the glide path stated for January 2016, there is prima facie a strong case for a rate cut. The only impediment is that it could rise again after December when the high base effect weans. But yet, it will definitely not come close to the 8% path set for January 2015, and will hence; still justify a rate-cut action.
The question really is that once we attain an inflation target and then lower interest rates—which can still be some distance away if we go by the technical paper which talks of an inflation rate of 4% with a band of 2% either ways—then how does one calibrate policy? Today, the market believes that as long as inflation is within these pre-set ranges, the path is known. But once attained, how would RBI react to ensure that these targets are still relevant?
The curious thing about monetary policy is that it should be unpredictable to be effective. If everyone expects rates to come down, then the market swallows this information and the result will be neutral. Hence, the Rational Expectations School led by Thomas Sargent and Neil Wallace argued that if policy rates are fixed and followed, then it would not affect growth as everyone adjusts to this scenario. By fixing these inflation-targets and linking action with these goal posts, investors would broadly know when interest rates would increase or decrease. As a corollary, the only way policy could work is in case the monetary authority stated its stance to begin with but then changed direction based on other considerations.
Otherwise, much like the famous efficient-market hypothesis, the interest rate would always be in equilibrium with information symmetry. The former says that if the market is efficient and all the information is available to all market players, then the market price would reflect the collective wisdom and be the right one. Right now, the GSec rates are moving down as it is expected that RBI will cut interest rates either in December or February as inflation has come down. Therefore, if RBI actually cuts rates now, the impact could be limited as the market has already absorbed this move.
But suppose, inflation increases after the series of interest rate cuts start, will RBI necessarily increase rates? It could use the concept of inflationary expectations to tarry for some time but rates have to be increased once we are committed to inflation-targeting. Not doing so would mean a serious deviation from the stated path. Hence, the element of surprise will never be there once we target inflation with specific goal posts. Growth, too, will not be affected as ‘rational’ agents know what to expect in advance. Policy would hence be targeting inflation which would be the monetarist stance.
At present, the revealed approach has been to target the inflation rate and stay there till there is conviction in the ‘glide path’ of inflation. Curiously, RBI had actually brought in an element of surprise when the Governor took over by doing the unexpected by raising interest rates. Or rather, the market was surprised when Raghuram Rajan took over as it quite irrationally expected a rate cut given that this was the time when there was a perceived difference of opinion between the finance ministry and RBI on interest rates when the change of guard took place. This gave an indication that RBI would follow the Rational Expectations approach but after the expert committee recommended inflation-targeting, which has been accepted, the logical corollary has been to remove the element of surprise.
The advantage of having an inflation-led monetary policy is that it allows agents to take decisions in advance. Presently there is expectation of a rate cut, but assuming inflation goes up at some time, then it would be logical to expect an increase in rates once these benchmarks are attained. Accordingly, decisions like long-term investment can be taken or slowed down based on these paths.
However, it must be realised that while policy targets retail inflation the measures per se may not have a bearing on the direction of this inflation. Food items, housing, transport, fuel, have a share of around 90% in CPI, which is normally not leveraged. Clothing, footwear and, probably education, with a weight of 10% could be financed through credit at the margin. Hence, when RBI follows the path of inflation-targeting, it could end up being a passive follower of inflation with policy changes being more a reaction to prices and not quite a controller of the same.
This scenario could be a valid outcome of the ‘glide path’ where interest rate policy waltzes with the inflation number without quite affecting it. Growth must then look for other policy impulses. Also, at the ideological level an issue that can be debated is that if we follow inflation-targeting, should we be having monetary policies or reviews periodically or go back to the two-policy per annum approach with announcements coming in when these inflation numbers are attained.
The author is chief economist, CARE Ratings. Views are personal