In the forthcoming mid-quarter review there are two policy issues that should be engaging the immediate attention of the Reserve Bank of India, namely, price stability vis-à-vis growth and the stabilisation of the exchange rate.

At his first press conference, the governor, Raghuram Rajan, read out the preamble to the RBI Act, which gives the mandate on ‘monetary stability’ by which is meant maintenance of the purchasing power of the rupee.

Like his predecessors, Rajan has interpreted it to mean low and stable expectations of inflation. For nearly a half-century after its establishment, the RBI never talked about an ‘acceptable’ or ‘tolerable’ inflation rate of 4-5 per cent, as it has been doing after accepting the recommendation of the report of the committee to review the working of the monetary system in 1985. If prices go up by 5 per cent year after year on a rising base, it would lead to an eventual rise of 240 per cent at the end of 25 years, not 125 per cent. It is the tyranny of compounding.

If we consider the quarter century before and after the middle of the 1980s, there was excessive money creation to the extent of Rs 30 trillion, considering the growth in GDP and a liberal estimate of Income Elasticity of Demand for Money at 2 from 1984-85 (that is, the demand for money grows at double the rate of the increase in income). (See “Curtain-Raiser for Monetary Policy of RBI 2010-11”, BL, April 14, 2010.)

The committee regarded the acceptable rise in prices as 4 per cent to reflect changes in relative prices necessary to attract resources to growth sectors.

Misperceptions

This hypothesis was not tested by the Committee. However, studies in the US and Sweden have shown causality flowing from general to relative price variability, and not the other way round. According to Lucas, misperceptions of relative prices induced by inflation could lead suppliers to mistakenly increase their output, at least for a while.

The operational implications of the distorted interpretation were explained in an earlier article, showing that the acceptable 5 per cent price rise only assures the country of a minimum inflation rate of that order! But to interpret monetary stability as the stability of inflation rate, and not of the general price level, is a distortion of the mandate. As a caveat, let me say that no one interprets the mandate as a zero rate of inflation.

The proposed monetary panel could ponder over the definition of monetary stability. It may pose problems for the central bank and the Government! But it is a matter affecting millions of people. It could also examine whether the 5 per cent inflation limit could be reduced further. The US,, UK, ECB and now Japan have it at a much lower level, even though their citizens are economically better placed to bear a higher rate than the average Indian.

As I had suggested about 15 years ago, it is time for the Government to appoint a high-powered commission to formulate a new law to replace the existing RBI Act. It could lay down a preamble giving a clear definition of monetary stability, besides incorporating other objectives such as growth. (The US Fed has triple objectives.) The Financial Sector Legislative Reforms Commission (FSLRC) missed a chance to recommend such a legislation. Next year will see the completion of 80 years of the RBI Act, 1934.

It should be the occasion to start preparations for the enactment of a new law, after the Government takes decisions on various recommendations of the FSRLC.

Exchange Rate

The RBI will do well not to intervene in the forex market. The bank can use administrative instruments, in conjunction with Government, to tackle the problems of inviting foreign capital and stemming outflows.

I would suggest that it remove whatever restrictions still remain on interest rates on NRI deposits. It may also consider reducing the period given for the repatriation of export proceeds from nine months to six months, as was the case for a long time.

The time limit was extended when the rupee was appreciating due to forex inflows; that is no longer the case. The exporters may be assured that the old limit will be restored once the forex market stabilises.

Since there has been no abatement of inflation, the RBI cannot think of reducing the cash reserve ratio. The reduction in SLR will have to wait, considering the strained status of the fisc and the rising yields on gilts. In view of the clamour for a reduction in interest rate -- and the fact that the Annual Report (2012-13) has admitted that its hard stance is one of the factors causing the decline in the growth rate --- I suggest a strategy that would meet the RBI’s viewpoint and also help promote public relations.

The rate for Marginal Standing Facility (MSF) could be reduced to indicate liberalisation, while the other rates may be retained in view of the difficult situation on the price front. In view of the heavy drawals on MSF and the liquidity drain from the system due to advance income tax payments, the RBI may also consider relaxation of the quantitative limit on repos by a few basis points.

The monetary panel may consider the feasibility of Open Market Operations of the type undertaken by the Fed to align the money market rates with the Federal Funds Rate.

(The author is a Mumbai-based economic consultant.)

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