The Hindu Business Line : Reflections on Monetary Policy review

The central bank has to practise the art of the possible. The October mid-year review of Monetary Policy will continue to lay emphasis on institutional reforms. On monetary policy measures, the die is already cast, says A. Vasudevan.

IN A comprehensive statement to the International Monetary and Financial Committee that convened on October 2 at Washington DC, the Finance Minister, Mr P. Chidambaram, made some interesting remarks about central banking and monetary policy, the import of which should not be lost at the time of the mid-year review of monetary policy.

Speaking on the recent oil price increases, the Minister said that compared to the earlier oil price shocks, "countries have become more resilient through the pursuit of sound macroeconomic policies. Central banks have developed tools and communication policies to achieve price stability without causing serious disruption to the recovery currently underway. We also notice that the policy reversal to a neutral or moderately higher interest rate regime is expected to be gradual and phased in a guarded manner. However, the combination of risks of oil price and reversals in monetary policy regimes make the management of macro-policies on oil-importing emerging economies a particularly complex task."

Referring to the developments in India, he remarked, "... the current outlook for oil prices makes the macro-economic management in India very complex. Monetary policy will continue to emphasise price stability with growth."

In the first quotation, the reference to reversal to a neutral or moderately higher interest rate is to the US Federal Reserve policy. But how does one view the sentence about the emerging economies in the same quotation?

Does it mean that the Fed approach in the context of oil price increases has made policy management in emerging countries complex or does it suggest that given the present oil price situation, policy regime reversals in emerging economies could complicate macro-policy management?

Under the former interpretation, the Fed policy would be acknowledged as impacting not only the US but also the emerging economies. Perhaps this is not intended. Under the latter interpretation, regime shifts in India in terms of either liquidity condition or interest rate policy are ruled out.

The liquidity condition was tackled last month by raising the cash reserve ratio to check the credit increase that is being encouraged as a strategy to maintain the growth momentum. There is little scope for more initiatives on the quantitative aspect of policy.

As regards the interest rates, the policy intention seems to be to `stabilise' them by open market operations or liquidity adjustment facility, although one does not know the key interest rate that would be the focus of stabilisation.

However, one can be reasonably certain that rate stability would not be defined in order to avoid market reactions to neutralise policy impact.

On the other hand, efforts would be made to stabilise rates around the present levels within a broad band, say of 1 basis point to 200 basis points. After all, such stabilisation would serve the objective of reserves build-up being pursued as `self-insurance' mechanism, since interest rates could be edged up sufficiently to sustain capital inflows.

Besides, it would be consistent with the likely widening of fiscal deficit, not to speak of the `crowding-out' effect associated with it. Moreover, rate stability would be perceived as investment-friendly and market-related and as continuation of the monetary policy regime.

Finally, bankers could be under what could be termed as `rate illusion' in the context of the large portfolio of government securities they hold.

The above reasoning is not cynical. In recent times, one has come to acknowledge the central bank's communication skills as unrivalled, given the need to reconcile different, often conflicting policy objectives.

This takes us to the second quotation with which this article began. Monetary policy, it is said, would continue to emphasise "price stability with growth" — a nuanced deviation from the general perception of monetary economists that price stability and financial stability (that is, safe and efficient payment system) have to be pursued as main objectives while growth and employment creation would be taken up as long-term objectives only if they can be reconciled with the main objectives.

The central bank in India is unfortunately in a box, not of its creation. Ordinary men and market participants in India do not care for niceties of logic about policy.

Nor do they have patience to wait for policy impact beyond a short period and to appreciate the existence of lags in policy. As a result, price stability is often undefined; when it is done, it is usually a projection, not a forecast based on any model.

The Minister's observation is correct to the extent that monetary policy should influence inflation.

Analytically speaking, inflation is influenced by changing a key rate that helps to stimulate or depress demand for balancing demand and supply. This would, in turn, impact the utilisation of resources and inflationary pressures.

All this would mean that one should know the parts of total demand — consumption as well as investment. If consumption is dominant, then one needs to know of households' behaviour better than is available from data.

In particular, the household indebtedness, the demand of households for variety of assets (houses, equity shares, foreign exchange assets, durable goods and so on), the prices of these assets, the initial wealth endowment of the households, and the very size of wealth would all need to be factored in to get at the inflation forecast, besides the cost trends and the relation between demand and productive capacity.

India's central bank has very few details about the composition of demand to work with. Nor is it certain about the wealth effect (what an individual consumes during her life time) and the balance-sheet effect (the possibilities of obtaining loans and consume when the individual has large collateral to offer).

It, however, has data about the current valuation of some assets, the cost of borrowing, and a few macroeconomic indicators such as fiscal and balance of payments position and industrial production. It has no idea of the lags in policy. It has to therefore focus on what is deemed as investment and formulate policies that seem to be effective within a short period of time.

In such an environment, decisions about interest rates would be credible if they are perceived as `soft', because they would supposedly promote investment and thereby growth. One, however, has not seen enough evidence showing that investment growth depends on low interest rates.

More surprisingly, no recognition is given to the fact that low interest rates often breed inefficient use of scarce capital especially when one is certain about huge investment demand.

Such a sub-optimal use is best reflected in the size of the fiscal deficit. When the fiscal deficit is already high and is likely to go up, Governments would try to economise on interest costs.

Since banks hold a large portfolio of assets in the form of government securities, and would have to increase their investments in government securities to accommodate the further widening of the fiscal deficit, their interests too lie in a soft interest rate regime. Had the deficits been reined in, bankers would have shopped for good borrowers.

Besides, low interest rates in an environment of inflation could lead to financial disintermediation, especially if deposit rates are negative in real terms.

This could lead to flight of private savings to other markets, such as stock markets. In the event, monetary authorities would have to be wary of asset price movements as well.

The central bank today has to practise the art of the possible. The October review would continue to place emphasis on institutional reforms. On monetary policy measures, the die is already cast.

(The author, former Executive Director of the Reserve Bank of India, can be accessed on asurivasudevan@hotmail.com)

More Stories on : Monetary Policy | Economy

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Fiscal gravy train halts

Filial fickleness

Information security in the matrix of Mahabharata

The millstone of bad loans weigheth

US elections: Which way will women swing?

Reflections on Monetary Policy review

Lying comes naturally to human beings

Press Note 18

Foreign funds