Most expert views in India are in fact an ex-post opinion for every ex-ante fact
The reactions to RBI rate cut throws up a lot of pointers to the experts’ understanding of monetary policy. It is not an exaggeration to state that Indian analysts and a very large fraction of Indian policy “experts” are still in the 20th century, if not earlier, in their understanding of monetary, fiscal, and exchange rate policy. This is particularly evident in this increasingly complex, globalised and interdependent world. Don’t get me wrong—it is not a case of “I understand it and you don’t”. Rather, the case is that I don’t understand it, but at least I, like most outside India, am trying to come to grips with my lack of understanding.
Herewith six illustrations of our zone of deliberate ignorance.
January 15 rate cut: A common perception about the beginning of rate cuts from extraordinarily high rates is that RBI Governor Raghuram Rajan was forced to do so by an excessive amount of political pressure from government and industry. It is safe to assume that industry and government will always want rate cuts—and that industry always applauds government when it presents the budget every year. But what happens when what the industry wants, and the central government desires, is exactly what the central bank should want and desire? Unfortunately, many experts have failed to see this connection.
Rupee: Some experts felt, and perhaps continue to feel, that the rupee is overvalued and that the week-long appreciation of the rupee before the rate cut (from 63.6 to 62 per dollar) was a sign of RBI buying rupees in preparation for this cut, with the logic being that a rate cut induces depreciation. As readers of this column know, it has been my consistent view, and supported by evidence, that currency values respond a lot more (more than 90%) to growth differentials (and the expectations thereof) than to differentials or changes in interest rates. Contrary to traditional expectations, the rupee has actually appreciated by about 1% against the dollar (and a lot more against the euro) since the rate cut. And this, despite the turmoil in the currency markets caused by the Swiss National Bank delinking from the euro. Incidentally, about six hours after the rate cut, the Swiss franc appreciated by about 35% against the euro in a matter of an hour—such was the mayhem in the currency market during which the rupee strengthened against the almighty dollar.
No logic needed for an opinion: Just a day before the rate cut, on Wednesday, one pink newspaper had an editorial saying that the RBI was in no position to cut rates now because Greek elections were likely to cause currency turmoil, the rupee would weaken, and hence the RBI might regret having cut rates. Let me see if I get the logic right. Inflation is high, the rupee weakens, so one should not cut rates. Inflation has collapsed, the rupee will weaken, one should not cut rates! Of course after the cut, the rupee rallied—why? Because equity prices were rising! That is the expert opinion in India—an ex-post opinion for every ex-ante fact.
No more premature baking, please: There will be no effect on equity prices if RBI cuts by only 25 basis points because such a cut is already “baked-in”. We all know what happened on Thursday in the equity market. In the middle of a rate change cycle, equity prices (sometimes) do get baked-in. The beginning of a cycle—almost never.
Rise above the base effects: For one whole year, RBI, and most analysts in genuflection to the leader, have let monetary policy be a hostage to the “base effect”. What is this powerful “base effect”? In December 2013, the annual y-o-y inflation declined to 9.9% from the preceding three month average of 10.4%, and from the November 2013 level of 11.2%. Typically, because of fresh food produce hitting the market, food prices fall in December and seasonal factors indicate that the overall price index should fall by 0.8% m-o-m. The CPI index was 138 in December 2013 and 139.4 in November 2013, a fall of 1%. Is a 0.2% extra decline in prices in one month enough to make the economy wait for one whole year for the much-needed rate cuts? In December 2014, the data that helped goad RBI to cut rates, the decline in the price index was only 0.4% when seasonal factors indicate prices should have fallen 0.8%. Oops! Time for RBI to raise rates since prices did not fall as much as base effects.
The “base effect” game is a mugs game, which is why most analysts, and most central banks, do not play it. Just Google “base effects” and see what you find—base effects outside of India are like the invisible hand, nowhere to be seen. Waiting for base effects to appear, or correct themselves, is akin to waiting for Godot. It is hoped our central bank will lead India into the 21st century and introduce seasonal adjustments to data—if they do so, by definition, there will be no base effects unless something shockingly extraordinary happens in a particular month.
Junk the junk: What about RBI’s inflationary expectations survey? One of the primary reasons for the delay by RBI in starting the rate cutting cycle was because of its quarterly inflationary expectations survey which showed a perfectly negative relationship of expectations and CPI inflation. Stated differently, as inflation halved from the levels of a year ago, expectations of inflation went on increasing. The latest expectations survey (December 2014) shows, finally, a decline in inflation expectation to less than double-digit levels (9%). This fact was cited by Rajan as one of the reasons for a rate cut. But a straightforward question for all the inflation hawks at RBI: Since when was high expectation of inflation of 9% low enough to warrant a rate cut? I fully agree that interest rates should be cut—but not because a junk RBI survey shows a decline in inflation expectations to a high 9%-level. Better to junk junk than to offer it as an explanation—it makes all of us look bad.
This is all in the past, thankfully. Time to look at the future and attempt to answer the more enlightened question—how much interest rate reduction is consistent with the state of the Indian economy (growth and inflation)? For that though, tune in again to this column, soon. And thank you for reading!
The author is chairman, Oxus Investments and a senior advisor to Zyfin, a leading financial information company. Twitter: @surjitbhalla