1. Monetary policy is not everything

Monetary policy is not everything

The new Governor would be successful if there are no headlines about RBI by the end of his term

By: | Published: August 29, 2016 6:21 AM
A bigger compliment is due to the government for having instituted and followed a systematic and formal process in the selection of the Governor of RBI. (PTI) A bigger compliment is due to the government for having instituted and followed a systematic and formal process in the selection of the Governor of RBI. (PTI)

First, compliments where they are deserved. To Urjit Patel for having won the hot seat (he may be foreign-born, but is PIO; so, phir bhi dil hai Hindustani). Along with Stanley Fischer, who is Zimbabwe-born, Patel is the second East African to be a Central Bank Governor of a country other than his native one.

A bigger compliment is due to the government for having instituted and followed a systematic and formal process in the selection of the Governor of RBI. One can only hope that, in the future, whether it is the appointment of the CEA or the vice-chairman of NITI Aayog, we will see a similar process.

The more rational and open the process, the more the incumbents in such positions will have legitimacy.

That said, we must be wary of overloading our expectations of what a new Governor can do. Patel has been receiving much advice.

Somehow, the attack on Raghuram Rajan and, no doubt, his high profile have given the RBI job and central banking a much higher profile than used to be the case in India. In this, India has lagged behind the rest of the world.

Central bankers used to be grey eminences barely known outside a select circle. Who, for example, remembers William McChesney Martin who was Fed Chairman for long years, overlapping the Eisenhower, Kennedy and Johnson administrations?

Then the pendulum swung and Alan Greenspan was seen as some sort of Superman. Monetary policy was all, while fiscal policy was constrained by the fear of the bond markets. In 2008, came the crash. But we just changed our Gods. Greenspan was flawed, but Ben Bernanke was the new God. QE was the answer to all problems.

Now, we see that monetary policy has limits to its effectiveness. All that we had learnt about the transmission mechanism turned out to be useless.

Despite the QE flooding the economy with money and interest rates going nearly to zero, there is neither inflation nor income growth unlike what Friedman used to assert. Monetary policy may be the only game in town, but it is a dull one.

Of course, that is for them, not us. In India, fiscal policy is alive, active and dominant. With some difficulty, Union Budgets are following a downward path on deficits but you cannot rule out a rush of blood come 2019.

Monetary policy is at least now put on a firm institutional footing, thanks to the Urjit Patel Committee report.

Even so, it will not be easy to hold the economy down to a low-inflation path. One obvious fact is that it is the inflation in the items of daily purchase—high-frequency purchase items—which is politically sensitive.

I would recommend slicing the overall inflation index by frequency of purchase bands. For high-frequency items, expenditure is positively related to price level.

You cannot postpone the purchase of fresh onions or fruit. You spend more money and curse the government. But it is a supply-side problem with no easy or quick redress, unless the government has a sensible stock-holding policy.

There is nothing the central bank can do about the supply-side issues, but it can track the high-frequency items more closely and emit red signals.

It will be the first and most difficult task of monetary policy to keep the short-run inflation rate within the targeted limits.

But no less difficult would be the other task of reducing rates to stimulate the economy as and when there is room. The country is schizophrenic about rates; savers like them high and borrowers low. But savers, especially provident-fund-holders and pensioners, are a powerful lobby.

The gap will fall on the central Budget unless the government can override the unpopularity. Lower interest rates are not passed on to borrowers by the PSU banks as they face neither competition nor a compulsion to show profits (or any other kind of efficiency).

Good transmission will require some tightening of PSU banks discipline. May be consolidation will help in this. Reduce the PSU banks to three or five and see the difference. Of course, privatising them would be the best but no chance of that.

But if RBI succeeds, low inflation is no less problematic. The debt-GDP ratio looks favourable now because the inflationary years of UPA II allowed the government to inflate its debt away.

Since many holders of debt are PSU banks, it is not clear who gains and who loses. Persistent low inflation will reinforce fiscal discipline. Old ideas of above- and below-line borrowing had a lot of sense.

Debt should only be incurred for investment and not consumption. But this requires honest definitions of both these concepts and no fudging.

Above all, Urjit Patel knows, and must remember, that monetary policy cannot do much. He would be most successful if there are no headlines about RBI.

The author is a prominent economist and Labour peer

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