In a modern middle-income fast growing economy high real interest rates hurt the economy—and the people.
The immediate MoF-RBI crisis has passed, and hopefully will not return. As many others have noted, time has come for the two sides to talk, and communicate. In (bit.ly/2DvfB71; hereafter Part I) I had documented some large inconsistencies in the RBI/MPC’s policies over the last two years. These inconsistencies led to the MPC systematically raising real policy rates beyond MPC’s own stated and desired levels of 1.25 %. We noted that the real rate had averaged close to 2.5% since October 2016.
Most central banks err on the side of caution—excessive caution means real policy rates of 50 bps above target. In India’s MPC, excess real policy rates have averaged more than double the maximum “error”. There is much discussion, perhaps even conclusion, by most economists that the dispute is about the MoF wanting RBI to part with some of its excess reserves. It is true that there is disagreement, and most reasonable economists believe that there are differences in views, and that it is common-sense to resolve these differences. Indeed, there was a lot of debate on this issue even before Urjit Patel became Governor in September 2016—most notably, an open dispute between two good-friends, joint paper colleagues, and colleagues in government, Raghuram Rajan and Arvind Subramanian. The latter believed that RBI should part with some of its excess reserves, and mostly for the reason that reserves were in excess of conventional global norms. Governor Rajan disagreed. What is so different today? Nothing. So why the angst?
Like debt management by RBI or MoF, this debate will continue. [One notable fact—most recent RBI governors have argued for debt management outside of the central bank (as in most parts of the world) when they are not at the RBI—as soon as they become governors, their views change!] Unfortunately, normal disagreements are being twisted into a debate about central bank independence. This is just plain wrong, and disingenuous. There is a news report (bit.ly/2yZB04p) that hints at RBI not performing its regulatory duties with excessive inter-group lending by ILFS. This issue needs open discussion rather than the false conclusion that any questioning of anything substantive is an infringement on central bank independence.
Such disagreements do nothing to improve communication between the central bank and the MoF and the public. Is this the new normal for India or will we get back to the old normal after the general election? I like the old normal—where issues are debated, questions are raised, and clarity achieved, even without universal consensus. I believe an important contributor to the RBI-MoF divide started to occur sometime in early 2017. My interpretation of the discord sequence is as follows. Demonetisation led to considerable uncertainty increase in the economy, and as correctly forecasted by RBI’s board in its approval note dated November 7, 2016, demonetisation was expected to have a “short-term negative effect on the GDP for the current year”. It did, and inflation also fell, real rates rose sharply, and RBI did not respond by cutting rates. Growth slowed down, and discord developed. Part I had documented the rise and rise of real rates; this article documents the rise, and rise, of positive MPC inflation forecasting errors. And there is a definite link in the forecast high-inflation-and-achieve-high-real-rates equation.
In their first three meetings post demonetisation (December 2016, February and April 2017), the MPC felt that inflation would accelerate from the 4.4% and 4.2% inflation rates (observed in Sept-Oct 2016 to 4.8% in Q1FY17. I have yet to find a single economist who has claimed (in writing) that the immediate aftermath of demonetisation (or any significant uncertainty increasing policy anywhere in the world) would be to cause a significant jump in inflation. Note also that experts at RBI/MPC were (correctly) anticipating a short-term negative effect on output. Their conclusion: output would decline, but inflation would accelerate! Most economists in India (outside of the MPC) were forecasting both a decline in output and in inflation. At the April meeting, RBI still did not believe its forecast of declining GDP growth (which declined to 5.8% April-June 2017), and maintained its April-June 2017 inflation forecast at 4.4%. Actual y-o-y inflation for April-June 2017 was 2.2 %.
The point about this detailed analysis of MPC policy is to underline the empirical fact that RBI/MPC experts have systematically forecasted too high inflation—and that this forecast of too high inflation has led it to recommend, and implement, systematically too high real policy rates which has had the expected negative effect on GDP growth, and has therefore depressed tax revenues and depressed fiscal spending—factors which both RBI and MoF should be concerned about.
Note that the assumption is that the Modi government wants to maintain fiscal discipline. Of course, the Modi government could go on a spending spree financed by an expanding deficit. But the MoF has made clear that it does not intend to do that, and it hasn’t done that—and too late now since it is just five months before election time.
Hence, is the real reason for the MoF/RBI discord the fact that the MoF feels that RBI led MPC has not conducted monetary policy according to its own RBI/MPC criteria and hence caused damage to the political economy in this election year? In my article last week, I had documented that RBI/MPC had implemented the third highest real policy rates in the world, and done so for the last three years. And that they further increased real policy rates by 50 bps in two back-to-back increases in June and August 2018. And all on the back of highly questionable (and, empirically, quite bad) forecasts of inflation. The graphic also reports on the forecasting errors pre- and post-MPC. In the pre-MPC period, the average forecasting error was 15%, i.e., on a base of 4% inflation, that is a one-quarter forecast error of 60 bps. Post-MPC (post Sept 2016) has (unexpectedly?) delivered a forecast error 50% larger than pre-MPC, i.e., an average forecast error of 23%, or, on a base of 4% inflation, the MPC has systematically estimated inflation to be nearly 1 percentage point (actually 0.92 points) higher than actual.
Today is the second anniversary of demonetisation. Besides all cash being returned to the system, there is NO argument that the demon attackers are against demonetisation. Proof for their conclusion is obtained from the fact that the media experts claim that cash today is higher than November 8, 2016—hence, demonetisation was a failure. No reasonable economist has yet stated that the transactions demand for cash has a zero elasticity of demand. If incomes (GDP) double, cash demand doubles. Between 2004/5 and 2015/16, nominal GDP grew at a CAGR of 13.4% per annum; cash in circulation increased at a virtually identical CAGR of 13.7%! In the 11 quarters since pre-demonetisation (Sept 2016 to Sept 2018), cash has increased by 8.3%; and nominal GDP is estimated to have increased by 23%; that is a cash-income elasticity of one-third the historical average. Yet, opposition experts claim that demonetisation had no effect on cash demand!
The economy, the poor, the SMEs and the farmers are hurt far more by erroneously high real rates than most factors ostensibly causing the present rift between RBI and MoF—theoretical central bank independence, adherence to Basel norms, or the sharing of RBI’s “excess” reserves.