Time has come for the Reserve Bank of India to go for bold rate hikes and stop putting out inflation estimates.
The markets are eagerly looking forward to the annual review of monetary policy by the Reserve Bank of India (RBI) on May 3. This year's announcement will mark the last of such reviews for the present Governor whose term expires in a few months. One hopes he will get an extension to complete a period of five years in office. In any case, he may like to examine a departure from the beaten track and leave his final stamp on policymaking. There is a need for fresh thinking on several fronts.
GROWTH, MONEY SUPPLY
Going by what experts have said on the prospects of GDP growth in 2011-12, it is not likely to be lower than 8.5 per cent with an upward bias, if the current trends continue and the monsoon turns out to be normal as predicted. The general practice has been for the Annual Review to predict the growth rates of GDP, inflation, deposits and money supply. In estimating the desired increase in money supply, the central bank multiplies the growth rate of GDP by the income elasticity of demand for money (reported to be 1.4). This is all very well. But then it adds 4-5 per cent to accommodate inflation. The RBI should find out how many central banks make such predictions, or provide for inflation.
With the exception of GDP, is it necessary to convey short-term money supply and inflation estimates to the public? While it can use the estimates for internal purposes there is no need to publish them as they turn out to be off the mark most of the time. This may be so in the case of GDP as well, but the public should have some idea of the growth estimate that has gone into policy formulation.
The central bank can assure the country by saying that the economy will not suffer for want of liquidity to achieve growth. With a GDP growth of, say, 8.5 per cent and income elasticity of demand for money at 1.4 the required growth in money supply to meet the demand should be around 12 per cent only.
In its recent policy announcements, the RBI has referred to the need to mop up the excess money injected into the system in the wake of the Lehman crisis. How can this be done if it routinely adds 5 per cent to the required money supply like the baker's dozen (‘kosuru' in Tamil and Telugu)? The sky is the limit for the creation of money by the central bank. It can always raise money supply by more than 12 per cent quickly in 2011-12 if it is warranted by the trends in growth and bank credit. Money supply (M3) increased by 150 per cent between March 2005 and March 2010 while the corresponding GDP growth amounted to 50 per cent.
The consequences on the price front with the lagged effects can easily be seen. Can the economy afford even a doubling of money supply between now and the next five years? The public tends to add two or more percentage points to the RBI's inflation forecasts, contributing to inflationary expectations. In view of this pattern, the central bank can say that it will pursue the objective of an inflation rate of two-three per cent in the medium term without mentioning any figure for the current year.
If five per cent is routinely given as the likely inflation rate every year, how can the medium-term objective of lower inflation be realised? The estimate for deposit growth results in banks trying to do even better, with window-dressing at the end of the year. Projections for deposits and money supply lose their reliability. It is time for an expert group to go into the modalities of window-dressing and recommend measures to deal with this menace. It could be under the leadership of a Deputy Governor, who has earlier been the chairman of a commercial bank.
If the RBI has not succeeded in containing money market rates within the desired corridor, unlike the European Central Bank, it is because of the Statutory Liquidity Ratio (SLR), which is absent in the latter. If the banks with surplus SLR securities can borrow from the RBI and onlend to others they will naturally do so at a rate higher than that of the repo. Considering the massive amounts of money raised in repos in recent times, it would have influenced the weighted average rate.
The solution lies in daily OMO. The Working Group on the Operating Procedure of Monetary Policy has recommended the reactivation of the Bank Rate by the institution of a collateralised Exceptional Standing Facility (ESF), with 1 per cent of the Net Demand and Time Liabilities (NDTL) of banks carved out of the required SLR portfolio. The danger is that banks will take this new facility as yet another entitlement, unlike now where the relaxation in SLR is allowed only for those banks that do not have surplus securities. It will weaken RBI control. The relaxation of SLR should be a rare event, as has been the case so far, and not a standing one.
A googly in cricket is effective if it carries an element of surprise. So is the case with monetary policy, according to some economists. The markets have already factored in a calibrated rise of policy rates by 25 basis points. The RBI could surprise them by raising the rates even more and following the suggestions above. Will the RBI deliver a googly?
(The article forms part of a larger study on monetary policy, which can be obtained from firstname.lastname@example.org.)
(The author is a Mumbai-based economic consultant. email@example.com)