The Hindu Business Line : Hawkish talk, dovish walk

A real hawkish policy would constitute moving to a gold standard for the currency besides allowing the markets to determine money supply and interest rates. But for the RBI's economists in the Keynesian mould that would be a near-180 degree shift from their intellectual leanings. The latest Monetary Policy is anything but hawkish, and given its highly inflationary implications, a year from now, the CRR, interest rates and the inflation could all be higher, says SHANMUGANATHAN N.

The RBI Governor, Dr Y. V. Reddy.

An earlier piece (Is our monetary policy `sound'? Business Line, January 11, 2007) had outlined as to how we can judge the efficacy of monetary policies. That method however requires market data spanning several years, perhaps even decades, and is more of a lagging-indicator. For a leading-indicator to predict the effects of a policy, we will have to use fundamental economic principles.

There are three economic parameters that provide an indication of the effects on a monetary policy. Listed below are the three parameters along with what would constitute a sound policy as against an inflationary policy. The advantage in viewing the policy against such a framework is that it offers a perspective beyond the spin that is associated with any policy announcement.

Central banker talk is usually littered with phrases such as "vigilant against inflation", "ready to deal with inflation when it arises" and these phrases are easily mistaken for action. When you objectively view against the parameters given in the Table, it is easy to see whether the central bankers walk the talk.

Centrist Policy

Of course, some of my more Austrian-minded colleagues would tell me that what I have described as a hawkish policy in the above framework is really a centrist policy.

A real hawkish policy would constitute moving to a gold standard for the currency besides allowing the markets to determine money supply and interest rates. But for our Keynesian trained economists at the Reserve Bank of India, that would be a near-180 degree shift from their intellectual leanings. So I would go one-step at a time here.

Having defined the framework, we can now look at how well the RBI has performed on the goal of delivering a sound monetary policy.

The industry participants and observers have been near unanimous in their approval by indicating that this is an inclusive, balanced and inflation-controlling policy. But let us see for ourselves as to how flawed these conclusions are:

Money supply: Money supply is projected to grow at 17 per cent for an economy that is projected to grow at 8.5 per cent indicating a highly inflationary policy. While this excess credit has been flowing into the financial markets and real-estate for the first few years of this decade, the trend has changed and this excess credit has started flowing into the commodities and agricultural products since.

This trend of agricultural products and commodities getting more expensive would continue much to the consternation of the RBI. Of course, our spin masters would be quick to jump to reasons such as supply constraints, infrastructure bottlenecks, growth and terror premiums as they have done before. The RBI Governor, Dr Y. V. Reddy added a new excuse of "globalisation" yesterday. The only surprise would be to see if they come up with any more new excuses as time goes by.

Real interest rate: The RBI survey shows the inflation in Dalal Street at 6 per cent or thereabouts. But the inflation in Living Street (refer Inflation: The Unusual Suspects, Business Line April 7, 2007) runs well ahead of that number. But even assuming that the RBI's inflation numbers are correct, keeping the repo rates at 6 per cent is hardly indicative of maintaining a healthy Real Interest Rate.

Time horizon orientation: Plenty of the short-term actions with no meaningful long-term plans for developing a vibrant economic system, for example, changes in risk weightage to sub-Rs 20-lakh house loans while little has been done for development of the bond market and capital account convertibility.

How these actions would bring down inflation is not quite clear. Dr Reddy, however, goes a step further and says that his medium-term target is to bring the inflation rate down to 4-4.5 per cent (readers would do well to remember that not too long back Dr Reddy's medium-term target for the Cash Reserve Ratio was 3 per cent). This would indeed be an economic miracle if it can be achieved.

A silver lining (though this is outside the preview of the policy) is that the RBI is not coming in the way of an appreciating rupee. But it is not certain if this supposed inaction is on account of the belief in market forces or due to lack of options.

Globally, we are at a point where most central banks have to choose between supporting a plunging dollar and dealing with inflation in their own economies. So this might just be a matter of inflation tying the hands of the RBI into keeping quite instead of artificially propping up the dollar.

At least by the first two counts, if not all three, this monetary policy is anything but hawkish. Given the highly inflationary implications of this policy, it is a fairly safe prediction to make that a year from now we would be seeing the following situation:

CRR would be higher by 150 basis points from where it is today.

Interest rates would be higher by 100 basis points from where they are today.

Even the RBI version of Inflation would be much higher than the 6 per cent today.

The RBI, meanwhile, would continue to give the usual story of how it would be ever vigilant on inflation and would act swiftly, forcefully and decisively. It has been saying this for the last couple of years and would continue to do so for the foreseeable future. But what is really amusing is to see even the majority of the industry believing in this spin.

(The author is a Director at Benchmark Advisory Services and can be contacted at shan.sundaram@ benchmarkconsulting.in. His previous articles can be accessed at http://financial-musings.blogspot.com)

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