The Hindu Business Line : Quarterly review of monetary policy

The RBI's open, pre-announced quarterly review on macroeconomic developments is historic and must commit the central bank to the current stance of monetary policy as it takes into account the multiple objectives of securing higher growth, price stability and financial stability. There are no real alternatives to this even if the instruments and objectives of the policy do not match at this point in time, says A. Vasudevan.

The quarterly review provides a unique opportunity to the RBI for promoting research in the art of monetary policy making. — Paul Noronha

FOR THE first time in the history of the Reserve Bank of India there is going to be an openly pre-announced quarterly review on macroeconomic developments and stance of monetary policy with the chiefs of the scheduled commercial banks by the end of this month. This is historic in the sense the review is going to be subject-specific and a quarterly exercise. What has made the RBI Governor call for such a review?

It could not be due to any expectation of substantive information about output prospects. As at the end of the third week of July, all one could get is an idea of production in the organised industrial sector up to May and of the monsoon conditions. But the organised industrial production data hardly represents one-fifth of industrial output and the link between monsoons and agricultural production can at best be a speculative guess. The output prospects of the service sector can only be guessed as trended.

Whatever the RBI puts out as the projected GDP growth is not based on any tested model but is essentially an informed expectation. However, it is possible that the projected 7 per cent growth rate for the current year would turn out to be right, given the past record of the limited deviation between the projection and the actual rate as given by the Government of India. Till the actual data emerge, it is necessary to consider the projection as not targeted.

If this logic is correct, the quarterly review is justified only if one were to assess the outlook about inflation, going by the well-known duality of objectives of monetary policy. Perhaps it has also to do with the perceived need to assess the developments in the international economy. For, there are the imponderable effects of the gradual opening of the Indian economy and the uncertainties about international crude oil prices and the choices that China may have with regard to its investments abroad and management of its foreign reserve portfolio.

The latter assessment is required to gain insights about the likely prospects of foreign trade and investment flows including non-resident deposits.

One doubts if the quarterly review was thought of at the time of the annual policy announcement, at end April, to examine the concerns expressed in the West about foreign currency volatility. For, the foreign exchange market in India is not very deep.

Besides, the RBI has done well to ensure that risks are hedged by the participants in the form of swaps, forwards and options through policy guidelines. Moreover, the exchange rate regime has been rendered `flexible' with cautiously calibrated capital account controls so that the monetary policy could be somewhat `independent'. In a sense, India has tried to harmonise what the economists call the `impossible trinity' over the last ten years or so.

The uncertainty about oil prices puts a question mark over the inflation outlook in the domestic economy. If the oil prices linger for too long at around $60 a barrel, it would be difficult to sustain the current pricing policy relating to the refined products of the crude and the existing cross subsidisation among the oil products from the point of view of fiscal health. But political economy considerations could well dictate terms otherwise.

In monetary policy work-outs, the changes in the wholesale price index from one point of time to another have always been considered as representing commodity price inflation. The consumer price index thus never figured as an adequate measure of inflation. The RBI would have nothing to say about the `services' inflation. In the scheduled quarterly review, one would expect the RBI to express concerns about the recent developments in asset prices, that is, the sharp rise in equity prices and the rising prices of real-estate.

Inflation thus measured does not make sense as it would hardly figure either in the portfolio calculations of investors or the income-expenditure budgeting of ordinary consumers. When services and asset price inflation outstrip the commodity inflation, as anecdotal and statistical evidence about equity price movements suggest, the RBI would be seriously concerned about the indebtedness of the households that have the best potential to save and invest. What happens when asset prices collapse or decline sufficiently enough to cause concerns? Faced with the high demand for housing loans, and the need to reduce exposure to the housing market, some financial institutions (for example, ICICI Bank) have raised their housing loan rates. This is the kind of response that institutions with sound research and analytical abilities would undertake.

The Finance Ministry has, on the other hand, been assuring that the interest rate regime would continue to be soft or benign. This viewpoint represents the highly romanticised but old world of macroeconomics. Its validity is doubtful even if the fiscal deficit is kept under check within the parameters of the Budget Estimate. For, there is little evidence of public investment pick-up. Nor is there much headway made in the area of infrastructure build-up. There is not even anecdotal evidence to show that productivity of expenditure on other heads, including primary education and health care, has shown improvement. The soft interest rate regime would, however, help keep the interest servicing cost of the government under check.

The current interest rate regime has also not helped the development of small and medium enterprises (SMEs) in spite of the expansion in overall bank credit over the last nine months or so. Credit for agriculture has gone up without showing any tangible results vis-a-vis rural employment.

The RBI has to contend with not only the Government's views, and the lack of credible evidence of credit-employment link, but also the growing uncertainty about the impact of oil price increases on the income growth of trading partner countries. It has also to examine whether asset price inflation is caused by credit flows both from the formal and informal financial sectors. Besides it has to take into account the strength of the connection that consumer spending has with asset price inflation.

Collapse of or significant declines in asset prices would normally reduce aggregate demand. In other words, both consumer spending and investment decisions would be affected by asset price declines. The good old macroeconomic textbook postulate that consumption is a function of income becomes irrelevant in these circumstances. The RBI would have to, therefore, give a signal that the accommodative monetary policy stance is not congenial either for future growth or for financial stability. It could even be in the innocuous form of an increase in the reverse repo rate as done in April.

The quarterly review should be used to commit the RBI to the current stance of monetary policy as relevant for the medium term as it takes into account the multiple objectives of securing higher growth, price stability and financial stability. There are no real alternatives to the stated stance of policy even if the instruments and objectives of the policy are not matched at this point in time.

The quarterly review provides a unique opportunity to the RBI for promoting research in the art of monetary policy making. For example, the RBI could make available the technical background papers prepared for the quarterly review to those interested in them.

The review also would help to enhance credibility and eliminate any lingering doubts about the fiscal-monetary policy coordination among many serious observers of the monetary policy. It would be interesting if the RBI takes the initiative to actively encourage the participation of the Government Director on the Central Board at the meeting. Simultaneously, the RBI should give an assurance to the chiefs of the public sector banks that they can air their views freely, without being influenced by the presence of the Government Director at the meeting. This problem can be partly resolved if the RBI brings out a detailed record of the review meeting for posting it on its web site. Such an initiative would also help improve the RBI's record of transparency practices.

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

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