MAVERICK VIEW. A new entente on monetary policy?

The December 2 monetary policy would have been difficult to formulate. The Reserve Bank of India, on more than one occasion in the past, has had to take a monetary policy stance different from what markets and the government desire. Rare has been the occasion when the RBI has disappointed powerful segments, yet these segments show appreciation of the RBI’s rationale.

In this sense, Governor Raghuram Rajan deserves unequivocal kudos for a persuasive presentation of the monetary policy. He has had the advantage of a government that appreciates the fact that the RBI has reason for deviating from the publicly declared policy line preferred by the government.

One fervently hopes that the climate of mutual respect and understanding will continue as the government and the RBI draw up an accord on the new framework of monetary policy.

According to the RBI Review, the global economy slowed down though it is expected that the recent sharp fall in crude oil prices will stimulate growth. While growth in the US appears to have strengthened, activity in the euro area has weakened. Japan may show a pick-up in growth helped by quantitative and qualitative easing, but activity in China is still low.

In the emerging market economies (EMEs) downside risks to growth appear to have been accentuated. Overall, the global outlook still looks uncertain.

Domestic activity over the past two quarters has been muted and agricultural output in 2014-15 is expected to be dampened. Again, the industrial and services sectors are sluggish, though there are signals of some improvement in the ensuing months.

A rise in investment is a prerequisite for increased economic activity. The fiscal situation is the cause of some anxiety with 90 per cent of the budgeted fiscal deficit having been utilised within the first seven months of the financial year.

The fall in crude oil prices will reduce the pressure on subsidies. While this would work towards lowering of the fiscal deficit, the quality of the fiscal deficit is perhaps as important as its size.

The deceleration in the Consumer Price Index (CPI) to 5.5 per cent on a year-on-year basis could be transitory as the base effect and seasonal factors wear off. Thus, in the ensuing months, there could be a resurgence of inflation.

The present year-on-year inflation rate of 5.5 per cent is even lower than the target of 6 per cent for January 2016 and therefore the target for March 2015 has been put at 6 per cent.

The RBI’s perception is that through to the period up to January 2016, the inflation rate could hover around 6 per cent.

It has been revealed that the future target of 4 per cent plus or minus 2 per cent set out in the Urjit Patel report could well be acceptable to the government and could, therefore, be part of any accord between the RBI and the government.

A strongly held viewpoint is that with inflation having come down, the RBI could rue its decision to maintain policy interest rates as it may have lost an opportunity to reduce interest rates.

Practical policy tensions are such that it is not possible to swing interest rates like the price of tomatoes from ₹80 a kilo to ₹20 a kilo within a few months and back to ₹80. Swinging policy interest rates wildly could have adverse fallouts as investor confidence could be eroded. Hence, interest rate policy changes have to be well calibrated.

The RBI in its policy statement has stressed that once the monetary policy stance changes it would be decisive and enduring. Since there were many uncertainties at the present time, the December 2, 2014 policy review left policy interest rates unchanged.

The RBI has given more than a hint that there could be a change in the monetary policy stance early next year, including outside the policy review cycle.

While forward guidance is the fashion of the times, belonging, as I do, to the ancient regime, I am somewhat uncomfortable with too categorical a forward guidance as the situation can change drastically in a matter of weeks.

Reading between the lines it would not be unreasonable to conjecture that an easing of policy interest rates could possibly be coterminous with the Union Budget in February 2015.

A tracking of past episodes of policy interest rate reductions around the Budget announcement are made coterminous with the Union Budget while any tightening is invariably after the Union Budget.

Point-to-point inflation targets are rather dicey and it would be more meaningful to have a medium-term inflation target which could be tracked as, say, a 36-month weighted average rate with a distributed lag.

Illustratively, if there is a target for a three-year period, in tracking the performance the weights could be 3 for the latest year, 2 for year t-1 and 1 for year t-2.

This way the target could be reasonably stable and the evaluation of the performance could be for a three-year period with a distributed lag and as such monetary policy responses would be smooth and random and volatile policy changes would be obviated.

One hopes that the accord between the RBI and the government will work towards a stable monetary policy. C Rangarajan’s seminal article, ‘Understanding inflation targeting’, in The Hindu (December 8, 2014) would be mandatory reading for all those interested in macroeconomics, and in particular officials in the RBI and the government dealing with drawing up the accord on monetary policy.

The writer is a Mumbai-based economist

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