Go Easy on Policy Rate Hikes

Bankers reportedly want a pause in the relentless rate hikes initiated by the Reserve Bank of India in recent months, with the policy objective of indicating higher interest rates and dearer cost of funds so as to arrest rising prices. They seem to face decelerating demand for credit, after the central bank has revised its key policy rates for lending and accepting deposits from commercial banks, as many as seven times in the past year. It is true that the RBI’s policy rate for providing liquidity to the system remains below the wholesale price index. But it is also a fact that the continuing price spiral has much to do with supply shocks such as rising crude oil and commodity prices, and buoyant prices of superior foods due to bottlenecks preventing stepped up supply in the face of heightened demand. Given that inflation in manufactures and attendant economic activity is more subdued, the continuing rate hikes across the board can well be questioned, although all indications are that the RBI would in the next several months go slow in the sheer pace of tightening monetary policy. To tackle inflation what’s certainly required is renewed policy attention, but in tandem we ought also to keep tab of credit offtake and the related output gap in the system and take proactive action. Given the panoply of rigidities on the ground, a lower than warranted output gap in goods and services can well rev up the price spiral and defeat the policy purpose of bringing down the inflation rate. The point is that on the issue of monetary policy design, we do need to aim for a nuanced approach when it comes to inflation and growth. In parallel, the pressing policy need is to probe the nonmonetary factors fuelling inflation such as inadequate cold chains, warehousing, and logistics coming in the way of much increased supply and consequent easier prices of protein-rich food articles. The point remains that even as we belatedly attempt to shift policy attention away from cereals, in tandem we need to be wary of the ceaseless use of direct monetary policy tools in the attempt to bring down the overall trend in prices. There seems also the need to re-examine the very conduct of monetary policy here, and compare and contrast it with the trends in the other major economies. For an economy like ours undergoing structural change and developing increasingly sophisticated markets, it would make sense to rely more on indirect controls in shaping monetary and credit policies. The transmission of monetary policy can be made more effective with greater financial intermediation and the better channelling of saving and investment. Abroad, in the mature markets, the fact is that monetary policy making is quite different today — and so is monetary economics — than say two decades ago, the trend has been apparent for over a decade now and precludes the recent financial crisis. The demand for money is far less stressed both for policy purposes and in the formal discourse, given that apart from banks, thriving bond and equity markets, there’s now a huge corpus of funds available with mutual funds, pension funds and insurance companies in the high-income economies. The financial development abroad has its flip side in runaway credit availability and over consumption, and the 2007-09 financial crisis homegrown in the US was essentially due to misplaced bullishness on new-fangled products like mortgage-backed securities even in the face of falling house prices and rising payment default. Be that as it may, the thriving market for single-name securities like conventional bonds, equities etc in the mature markets, to differentiate from the dicey structured products like mortgage-backed securities, has lead to a complete rethink in monetary economics and policy. Key central banks abroad no longer, say, target money supply. For years now, the workhorse model of the IS-LM framework used by central banks for policy purposes has been overhauled. The aggregate demand curve or IS remains in use for policy purposes, which relates the current output level to expected future production. There’s also the aggregate supply curve relating to current inflation and expected future inflation in the standard two-equation models of recent vintage. But the LM curve denoting the equilibrium of money demand and supply, which was a much used analytical tool for decades has been well neigh dropped in policy-oriented discussions, due to the marked development of financial markets oversees. It has led to proffering of policy rules like the Taylor rule, and calls to equate the key central bank policy rate with the GDP growth rate, so as to cool supposed overheating. Note that afew years ago RBI did peg its repo rate, the rate at which it provides liquidity to banks, at 9%, when the GDP growth rate was 9% as well. But the overall environment is different now; in any case we need to boost institutional development, intermediation and financial markets and de-emphasise direct controls, both in the monetary policy setting and otherwise.

ET