The Hindu Business Line : Monetary Policy — Irrelevance of consistency exercise

The areas to be addressed in the Monetary Policy have to be analytically sound and pragmatic. Should there be, in the policy statement, a consistency between money, output and prices? Asks A. Vasudevan, if the policy-makers opt for such a cons istency exercise as in the past, what would be their assumptions?

MONETARY policy is the one area where expectations of theory cannot be completely thrown overboard and that is why populist measures cannot, rather should not, be undertaken. The theoretical literature since the 1960s shows that economists have been studying as to how central banks react to economic conditions. React is the main operative word here. Economists believe that central banks can achieve a set of objectives by solving what they call an optimal control problem.

However, by the mid-1980s, with institutional or rather political factors playing a part, and with policy-makers showing a distinct preference for discretion in policy actions, reaction functions that help to know how a central bank uses the instruments of policy to attain its objectives have come under some cloud. In the Indian context, however, reaction functions have not been stated in clear-cut terms at any time. Instead, discretion is used on the ground that economic conditions could change quickly and policy-making has to be `forward looking'.

This is the time when the Reserve Bank of India (RBI) would be working out a `new' (new because it would coincide with the setting up of a new government) monetary policy. The RBI has been publishing the annual policy statement along with a document on monetary and economic developments since April 2000.

The `developments' document was originally intended to provide research support to the announced measures. However, this was watered down rightaway with the result the document has become colourful with graphs and statistical tables. It is more of a backward-looking document. The policy statement, on the other hand, contains some reasoning, albeit brief and opaque, for the contemplated measures. This is the time when the `developments' document and the policy statement are seamlessly integrated in a manner that the research input and the explanations behind the policy decisions are rendered clear, comprehensive and transparent. It would be a pity if this task is not accomplished for the May 18 new Monetary Policy announcement.

The areas that need to be addressed for the new policy have to be both analytically sound and pragmatic. The first thing to do is to ask whether one needs to have in a policy statement the consistency exercise between money, output and prices. This exercise, though informational, does not commit the RBI to any estimate that links the real income to the demand for money (what economists call the coefficient of income elasticity of money demand).

The consistency exercise gives an outer limit up to which liquidity could be afforded, given the estimates of output growth and commodity price inflation. If the estimates of growth and inflation rates are on target, money supply expansion can be easily explained assuming the said coefficient holds good. In case the money supply increases at a rate much higher than what is warranted, despite meeting the targets of growth and inflation, all that the policy-makers could do is to wink at the coefficient, thereby holding it to be the villain of the piece. But the coefficient would not change radically in the short run. Moreover, as financial markets develop with newer financial products, it becomes difficult to estimate the demand for money. This has been proved empirically in the case of many a developed country.

Despite these limitations, if the policy-makers opt for a consistency exercise as in the past, what would be their assumptions? Having secured over 8 per cent rate of growth in GDP in 2003-04, it is difficult to assume that GDP would grow at such a high rate in 2004-05. In fact, an estimate places it at around 6.5 per cent and it would be a surprise if the RBI would project a different growth rate. Since the central bank is interested in India being internationally-competitive, price-wise, it would like the commodity price inflation to be less than 4 per cent. Assuming the coefficient to be not more than 1.2, then money supply growth cannot be more than 12 per cent — a figure that has not been seen in the last 20 years. This would mean that there has to be a decline in the growth of M3 by about 400 basis points in 2004-05 from the estimated one of 16 per cent in 2003-04. Will this be engineered by the RBI through policies of credit contraction and constraints on capital inflows along with measures to encourage some capital outflows?

Consistency exercise is no longer as important as the behavioural factors that underlie liquidity. In 2003-04, both currency and demand deposits grew strongly while time deposits decelerated. While the former could be attributed to strong capital inflows, the latter has to do with the rate of return (net of risk) vis-à-vis the rates of return on other assets. The question that the policy statement has to address is: How farther should the soft interest rate policy be taken? Would the RBI continue to take a vague stance about the need to have soft interest rates for promoting investment?

Empirically, there is little to prove that investments have been highly sensitive to interest rates. The RBI, on the other hand, will have to recognise that as the world economy is on the road to recovery and as the industrial scene in India is showing signs of buoyancy, there is no need to signal soft interest rate policy.

In fact, it may have to eliminate whatever remains of the administered interest rate regime. In case an exception has to be made, as perhaps to reduce NRI deposit inflows, the RBI should give comprehensive explanations. Reduction of inflows can only be one reason, the other being to build into the edifice of liberalisation the checks and balances system. To signal the move towards interest rate flexibility, it is probably best to move up the bank rate by, say, 25 basis points and eliminate export refinancing and the refinancing rates.

But this course of action would not work unless the Governments agree to dear money policy and bear higher interest servicing costs on their debt. Exporters would oppose such a move. Small-savers, on the other hand, would wonder whether the banks would further lower the interest rate on saving accounts taking advantage of the freedom to determine interest rates.

The RBI's position is unenviable because the upward drift in interest rates is rarely recommended on grounds of what economists refer to as cyclicality in growth. But the revealed preference for interest rate hikes would serve a number of purposes.

For instance, there could be a shift in favour of time deposits and a reduction in the growth rate of demand deposits. This should facilitate asset-liability management better than what would be the case if demand deposits continue to post large increases. Besides, interest rate hikes would help moderate the current increases in the prices of financial assets.

(To be concluded)

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