What should RBI give weightage to decide policy rates? All you want to know

Published: November 21, 2017 4:49:14 AM

There seems no theoretical basis for the inflation targeting or its levels—not from IMF, not from Basel norms which aim at financial stability or RBI … By keeping currency overvalued for far too long (over a decade now), we are recreating conditions of 1991.

Policy rates, it appears, are currently decided mostly or solely on inflationary expectations. In deciding policy rates, perhaps the actual for the past two quarters should be given equal weightage.

The government seems to be in a bit of a bind over both employment and growth, not for all as its own making. One of the chief contributory to this morass is the inappropriate way the objectives of our monetary policy have been fixed or evolved over the last 6-7 years. The accompanying chart shows clearly the increasing misalignment between inflation, external value of the rupee (as reflected by REER) and interest rates caused by the recent shifts in our monetary policy. The chart uses WPI instead of the new-found CPI, which is 57% out of control of RBI’s policies as the report itself admits. Two main components as it operates in our Monetary Policy Framework are (1) to target a consumer price inflation of 4% with a tolerance of 2%—both the variable and its levels are recent developments—and (2) to aim at orderly conduct of forex markets without seeking to target any particular rates.

Fundamental flaws

Firstly, in both these, the targets are fixed without reference to any end-goals in mind. As if these are desirable self-actualising end-goals in themselves? In economics, everything is interconnected—inflation, interest rates, growth, employment, productivity, cost-competitiveness, etc. To seek a deterministic nominal goal in a web of influences looks naive at best. Secondly, the objective that the economy desires to achieve may vary depending upon the stage of growth. It can vary for the same economy from time to time. For the EU, it is kick-starting growth now; for China, it is to stabilise it at a high rate; for Japan, it is to grow—any growth—even if very low by international standards. For the US, it was about achieving any kind of growth after the meltdown, but now slowly crossing over to stabilising inflation. A nominal fixed target does not address these contextual concerns. Thirdly, economics is mostly about balance and trade-offs between what in general are opposing interests—buyers and sellers, producers and consumers, workers and producers, savers and investors, inflation and growth, and so on. One isn’t sure how a nominal deterministic inflation number can work towards an optimal or at least desired equilibrium between savers and investors, between domestic investments and imports at all times even in the medium term. Lastly, there is excessive and suicidal reliance on the nominal rather than real variables, which is what may be causing the current problem.

No basis

There seems no theoretical basis for the inflation targeting or its levels—not from IMF, not from Basel norms which aim at financial stability or RBI. While nothing can be exact about economics and hence a band is necessary for targets, a 2% tolerance on 4% is like permitting Usain Bolt to run on his track or the adjacent tracks on either side and the penalties for trespass being imposed two Olympics away. Just orderly movement of forex rates is no policy. When it is clear that it has a significant impact on domestic capacity utilisation, jobs and growth, to aim to only curb the volatility but not be concerned with the values, is naive shirking, much like driving without violating any traffic guidelines or speed limits but towards a wrong destination. By keeping the currency overvalued for far too long (over a decade now), we are recreating conditions of 1991 crisis.

Way forward

Keynes had brought out the true nature of the real and the nominal economy, the rigidities exhibited by the real and how to tweak it by using the nominal to achieve real goals. The current constant 4% inflation (nominal) target can in no way balance the interests between savers and investors, forever. The government should move to a 2% +/- 0.25% real interest rate regime. Whether the inflation is 4% or 9%, such a real interest spread of 2% will be a fair compensation to savers. It will also not curb investment urges if what investors have to pay out is in line with what they recover from the market through inflation in prices. This is a sort of inflation-proofing both savers and investors. Such a floating nominal interest (but largely fixed real interest rates) regime will largely ensure that fresh investments and savings do not grind to a halt. But the existing outstanding stock of savings are in fixed nominal interest regime, which poses problems. It is, therefore, necessary to move to a floating nominal rate regime and increase its proportion. In the last few years, bank loans have largely become floating rates with optional repayment and a significant progress has been achieved. It is necessary to increase the proportion of floating rate bank deposits from the savers’ side as well.

The second thing that is capable of derailing growth and employment in an open economy is forex rates. An overvalued currency makes imports cheaper and exports far less remunerative, which affects domestic employment and growth. A 20-22% overvalued currency, as on date, is a killer. The government should mandate RBI to walk it along in an orderly manner along the real values. RBI and the government should agree to maintain exchange rates within a band of 97-103 REER. This REER should be calculated on a base year that is sound when most economic parameters (CAD, fiscal deficit, inflation, growth, etc) are as close to our desired objective. As it stands now, 2004-05 is one such year. The government should also tailor its inward investment policies accordingly, and the degree of capital account convertibility must be tuned appropriately. Currently, policy rates, it appears, are decided mostly or solely on inflationary expectations. This can result in fear-mongering. In deciding policy rates, perhaps the actual for the past two quarters should be given equal weightage. By moving to the real from the nominal on both interest and forex accounts, we may have learnt the right lessons from Keynes. Excessive reliance on the nominal on both accounts have made India under-perform its potential in the last 4-5 years.

V Kumaraswamy
CFO, JK Paper, and author of ‘Making Growth Happen in India’

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