The Hindu Business Line : Monetary policy in uncertain times

What is the impact of the RBI's three policy rates on inflation and the shifts in output? How do the rising crude prices affect inflation? These and a dozen other issues need careful research if the monetary policy objectives of output/employment growth are to be achieved, says A. VASUDEVAN.

Monetary policy, most central bankers would declare with relish, is the art of the possible. This is true of many other policies as well. But `the art of the possible' argument helps central bankers determine policies on the basis of their best judgments of what is immediately credible. However, judgments, as Shakespeare would say, `should be made of sterner stuff' and backed by sound research.

The Reserve Bank of India (RBI) has entered a phase where its monetary policies are assessed for their content and credibility more closely than ever before.

This is because we now have almost 10 years of quarterly GDP data besides extensive daily quotes from the gilt, money, capital, bullion and foreign exchange markets and monthly information on bank credit by sectors/activities that could be subjected to quality quantitative analysis.

The RBI should be able to use the output data to work out ways of achieving one of its monetary policy objectives, that is, output/employment growth.

The only problem is with the information on prices — both of commodities and services. And the central bank may not be able to confidently tackle its other objective of price stability.

Inflation inertia

To underscore this point, let us take the case of one of the most discussed uncertainties these days — crude oil prices. The fact that oil prices have gone up over the last year is not probably as fearsome as the scenario of a further flare-up.

Though the present inflation rate, as measured from the movement of wholesale price index for all commodities, does not reflect a complete pass-through of the price of oil, the official view seems to suggest that the inflation rate, even when the complete pass-through is allowed, would not go beyond 5-5.5 per cent.

This view is different from those held during the oil crises of the 1970s and the early 1990s, when oil prices were said to have fuelled inflation. Why, then, is there what economists call inflation inertia of around 5 per cent? Is this because of the mistaken measurement of inflation in terms of wholesale prices or/and the structural shifts in the economy? Is neither money supply nor the liquidity position able to influence inflation?

Should inflation inertia be seen in terms of supply shocks? Should it be viewed in terms of the `general' price level and not in terms of relative prices? Is it a part of the perceived world-wide phenomenon of inflation inertia? Would this inertia continue if monetary policy regimes shift along with structural shifts without minimising the output gap — that is, between potential and actual output?

These are formidable questions. One has not had the benefit of sound research studies on these issues from the apex bank. Nor are these examined, sad to say, by researchers outside the bank. Explanations about inflation generally focus on the general price level, not on relative prices.

Many of them refer to supply shocks and give limited importance to the changes in aggregate demand, and the criticality of the shifts in structural and institutional framework. References to inflation expectations are generally historical and rarely imbued with a forward-looking perspective.

Essential research

The RBI would have to centre its research agenda on the questions raised here to improve the clarity about the role and impact of monetary policy and to eliminate, to the extent possible, the temptation to spring policy surprises.

Information is costly for market participants but they will try to extract signals from the articulated stance of policy.

Such extraction, however, is not sufficient to comprehend the forward-looking character of the policies. For, there is very limited knowledge now about lags in monetary policy.

Moreover, there are not many studies on credit cycles, the relationship between bank credit and firm size, the link between monetary policy and asset prices, the relationships between loan portfolio decisions and the associated risks in the banking and non-banking sectors, the extent of success of `price discovery' in the treasury and other markets and the impact on investors' decisions.

Neither do we have the benefit of many analyses on the extent of household debt and the effect of its collateralisation on macroeconomic stabilisation, mergers of banks and other financial institutions and their linkages with investor expectations and stock market reactions, and the problems that arise from information problems and the presence of different types of derivatives to help evolve informed market expectations.

These studies are now essential. For example, lags could be of different durations and unless their effects are known, it is difficult to make investment decisions that would impact on the aggregate demand in terms of the mix of consumption and investment.

Superimpose on such insights the ones from other studies as, for example, on credit cycles and on the linkages between monetary policy and asset prices.

In the absence of such knowledge, how does one typify the current monetary policy in terms of regimes? It is not led entirely by credit planning (read as sectoral credit targeting pursued from the 1970s to the beginning of the 1990s), nor is it reflective of monetary targeting (allegedly in vogue from 1993 to 1997). It does not also have any `implicit' anchor, such as the exchange rate or inflation rate. What we now have is a heady mix of regimes.

The three rates

The unwillingness to commit the RBI to any anchor or a targeting-variety to preserve policy discretion is evident from 1998. This has led to the use of the rate of interest and the exchange rate as adjustable policy instruments without being explicit.

The rates are to be neutral once the projected growth and inflation are realised. The adjustments are facilitated by day-to-day management of liquidity. But this, as the latest monetary policy statement indicates, would be replaced by regular open market operations. One has to ask as whether the announced shift implies that the rate of interest would play a more active role in future in minimising the output gap and maintaining inflation inertia.

Or, is it that the shift would be made to work along with such structural shifts as the use of provisioning as a way to induce sectoral interest rate hikes, as has been implicitly done by the last annual monetary policy?

This could well be so for it is consistent with the opaqueness about the policy rates. The RBI has three policy rates — the Bank Rate, the repo rate and the reverse repo rate — unlike the preference of most central banks to have only one. It is not clear why there are three policy rates.

One can understand the central bank's helplessness in mentioning the Bank Rate as a policy rate in view of the legal compunction. But what is the locus standi of the other two? How good is their impact on the inflation rate and the shifts in output? These questions need answers too.

The RBI has talented economists who, if given individual recognition and the requisite incentives, could be depended upon to generate studies that would aid a better understanding of the art of the possible.

(The author, a former Executive Director of the Reserve Bank of India in charge of research and monetary policy, can be accessed on asurivasudevan@hotmail.com)

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