In a speech delivered earlier this week at Tata Institute of Fundamental Research, Mumbai, Dr. Raghuram Rajan, Governor of the Reserve Bank of India, spoke about the criticism against his policies and defended his stance. Here is an extract from his speech.
The criticism
- Criticism 1: We focus on the wrong index of inflation.
- Criticism 2: We have killed private investment by keeping rates too high. Somewhat contradictorily, we are also hurting the pensioner by cutting rates too sharply.
- Criticism 3: Monetary policy has no effects on inflation when the economy is supply constrained, so we should abandon our attempt to control it.
- Criticism 4: The central bank has little control over inflation when government spending dominates (what in the jargon is called “fiscal dominance”).
The defense
Historically, the RBI targeted a variety of indicators, putting a lot of weight on the Wholesale Price Inflation, or WPI. Theoretically, reliance on WPI has two problems.
First, what the common citizen experiences is retail inflation, that is, Consumer Price Inflation, or CPI. Since monetary policy “works” by containing the public’s inflation expectations and thus wage demands, CPI is what matters.
Second, WPI contains a lot of traded manufactured goods and commodity inputs in the basket, whose price is determined internationally. A low WPI could result from low international inflation, while domestic components of inflation such as education and healthcare services as well as retail margins and non-traded food are inflating merrily to push up CPI. By focusing on WPI, we could be deluded into thinking we control inflation, even though it stems largely from actions of central banks elsewhere. In doing so we neglect CPI which is what matters to our common man, and is more the consequence of domestic monetary policy.
One reason critics may advocate a focus on WPI is because it is low today, and thus would mean low policy rates.
This is short-sighted reasoning for when commodity prices and global inflation picks up, WPI could well exceed CPI.
There is, however, a more subtle argument; the real interest rate is the difference between the interest rate a borrower pays and inflation – it is the true cost of borrowing in terms of goods like widgets or dosas.
If policy interest rates are set to control CPI, they may be too high for manufacturers who see their product prices appreciating only at the WPI rate.
I am sympathetic to the argument, but I also think the concern is overblown. Even if manufacturers do not have much pricing power because of global competition, their commodity suppliers have even less. So a metal producer benefits from the fall in coal and ore prices, even though they may not get as high a realization on metal sales as in the past. The true measure of inflation for them is the inflation in their profits, which is likely significantly greater than suggested by WPI.
A second error that is made is to attribute all components of the interest rate paid by the borrower to monetary policy.
For heavily indebted borrowers, however, a large component of the interest rate they pay is the credit risk premium banks charge for the risk they may not get repaid. This credit risk premium is largely independent of where the RBI sets its policy rate.
So when someone berates us because heavily indebted industrialists borrow at 14% interest with WPI at 0.5%, they make two important errors in saying the real interest rate is 13.5%.
First, 7.5% is the credit spread, and would not be significantly lower if we cut the policy rate (at 6.5% today) by another 100 basis points.
Second, the inflation that matters to the industrialist is not the 0.5% at which their output prices are inflating, but the 4% at which their profits are inflating (because costs are falling at 5% annually).
The real risk free interest rate they experience is 2.5%, a little higher than elsewhere in the world, but not the most significant factor standing in the way of investment. Far more useful in lowering borrowing rates is to improve lending institutions and borrower behavior to bring down the credit risk premium, than to try and push the RBI to lower rates unduly.
The policy rate in effect plays a balancing act. As important as real borrowing rates for the manufacturer are real deposit rates for the saver.
In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits. This meant that India needed to borrow from abroad to fund investment, which led to a growing unsustainable current account deficit.
In recent years, our fight against inflation also meant the policy rate came down only when we thought depositors could expect a reasonable positive real return on their financial savings. This has helped increase household financial savings relative to their savings in real assets, and helped bring down the current account deficit. At the same time, I do get a lot of heart-rending letters from pensioners complaining about the cut in deposit rates. The truth is they are better off now than in the past, as I tried to explain in a previous lecture, but I can understand why they are upset when they see their interest income diminishing.
The bottom line is that in controlling inflation, monetary policy makers effectively end up balancing the interests of both investors and savers over the business cycle.
At one of my talks, an industrialist clamored for a 4% rate on his borrowing. When I asked him if he would deposit at that rate in a safe bank, leave alone invest in one of his risky friends, he said “No!” Nevertheless, he insisted on our cutting rates significantly. Unfortunately, policy makers do not have the luxury of inconsistency.
Supply constraints
Food inflation has contributed significantly to CPI inflation, but so has inflation in services like education and healthcare.
Some argue, rightly, that it is hard for RBI to directly control food demand through monetary policy. Then they proceed, incorrectly, to say we should not bother about controlling CPI inflation. The reality is that while it is hard for us to control food demand, especially of essential foods, and only the government can influence food supply through effective management, we can control demand for other, more discretionary, items in the consumption basket through tighter monetary policy. To prevent sustained food inflation from becoming generalized inflation through higher wage increases, we have to reduce inflation in other items. Indeed, overall headline inflation may have stayed below 6 percent recently even in periods of high food inflation, precisely because other components of the CPI basket such as “clothing and footwear” are inflating more slowly.
Fiscal dominance
Finally, one reason the RBI was historically reluctant to lock itself into an inflation-focused framework is because it feared government over-spending would make its task impossible. The possibility of fiscal dominance, however, only means that given the inflation objective set by the government, both the government and the RBI have a role to play. If the government overspends, the central bank has to compensate with tighter policy to achieve the inflation objective. So long as this is commonly understood, an inflation-focused framework means better coordination between the government and the central bank as they go towards the common goal of macro stability. I certainly believe that the responsible recent budget did create room for the RBI to ease in April.
Pragmatic inflation focus
As you will understand from all that I have been saying, monetary policy under an inflation focused framework tries to balance various interests as we bring inflation under control. In doing so, we have to have a pragmatic rather than doctrinaire mindset. For example, emerging markets can experience significant capital inflows that can affect exchange rate volatility as well as financial stability. A doctrinaire mindset would adopt a hands-off approach, while the pragmatic mindset would permit intervention to reduce volatility and instability. Nevertheless, the pragmatic mind would also recognize that the best way to obtain exchange rate stability is to bring inflation down to a level commensurate with global inflation.
Similarly, while financial stability considerations are not explicitly in the RBI’s objectives, they make their way in because the RBI has to keep growth in mind while controlling inflation. So if the RBI’s monetary policies are contributing to a credit or asset price bubble that could lead to a systemic meltdown and growth collapse, the RBI will have to resort to corrective monetary policy if macro-prudential policy alternatives are likely to prove ineffective.
The transition to low inflation
The period when a high inflation economy moves to low inflation is never an easy one. After years of high inflation, the public’s expectations of inflation have been slow to adjust downwards. As a result, they have been less willing to adjust their interest expectations downwards. Household financial savings are increasing rapidly as a fraction of overall household savings, but not yet significantly as a fraction of GDP.6 Some frictions in the interest rate setting market do not also help. Even while policy rates are down, the rates paid by the government on small savings are significantly higher than bank deposit rates, as are the effective rates on tax free bonds. I am glad the government has decided to link the rates on small savings to government bond rates, but these rates will continuously have to be examined to ensure they do not form a high floor below which banks cannot cut deposit rates. All in all, bank lending rates have moved down, but not commensurate with policy rate cuts.
The wrong thing to do at such times is to change course. As soon as economic policy becomes painful, clever economists always suggest new unorthodox painless pathways. This is not a problem specific to emerging markets, but becomes especially acute since every emerging market thinks it is unique, and the laws of economics operate differently here. In India, at least we have been consistent. Flipping through a book of cartoons by that great economist, RK Laxman, I found one that indicated the solution for every ill in 1997 when the cartoon was published, as now, is for the RBI to cut interest rates by a hundred basis points. Arguments change, but clever solutions do not.
Decades of studying macroeconomic policy tells me to be very wary of economists who say you can have it all if only you try something out of the box. Argentina, Brazil, and Venezuela tried unorthodox policies with depressingly orthodox consequences. Rather than experiment with macro-policy, which brings macro risks that our unprotected poor can ill afford, better to be unorthodox on microeconomic policy such as those that define the business and banking environment. Not only do we have less chance of doing damage if we go wrong, but innovative policy may open new paths around old bottlenecks. Specifically, on its part the RBI has been adopting more liberal attitudes towards bank licensing, towards financial inclusion, and towards payment technologies and institutions in order to foster growth.
You can read the entire speech here.
