RBI takes the right decision

The Reserve Bank of India (RBI) should be congratulated for making no changes in the policy rates in its mid-quarter review of monetary policy. It has once again underscored its single-minded focus on monetary stability, as mandated in the Preamble to the RBI Act, 1934.

Its clarity of purpose is remarkable, given that pressure was brought on it from the government and the corporate sector to bring down policy rates, on the ground that growth had been stymied by the current regime of high interest rates. No one can fault the central bank on the spirited manner in which it has defended its policy to maintain the status quo in the interest of fighting inflation.

Short, Long-term Rates

Those who argue for a reduction in policy rates should distinguish between short-term and long-term rates relating to finance for production and investment, respectively. One can learn from the experience of the US Federal Reserve.

It has kept the short-term rates near zero. This has not helped in giving a sustainable kick-start to output growth in the economy. Since it did not also lead to the expected decline in long-term rates that determine investment, it engaged in Operation Twist programme of $400 billion, trying to twist the yield curve by selling short-term securities from its portfolio while buying longer-term securities.

As the yield determines the interest rate, declines in long-term rates were expected to help in lowering those on 25-year mortgages, car loans and other lendings, providing a stimulus to aggregate demand and growth. The results available so far are, however, not encouraging.

While the intended change in the portfolio of the Fed has been realised, the impact on the economy is muted, as researchers find that other factors, such as foreign demand for US goods and services and expectations of growth and inflation, are not favourable.

It is worth recalling that on the last occasion in 1961, when a similar programme was attempted in the US, it resulted in lowering long-term rates by only 15 basis points. Hence, rates alone do not determine demand when there is pessimism and risk aversion, not only on the part of lenders but among borrowers, after their miserable experience in the recent period.

Stock and Flow

Currently, in India, the fall in real aggregate demand, as against nominal demand, resulting in lower production, is due to the high level of prices (See RBI: Hard Choices, Easy Options , June 12). As in the case of many economic variables, one should distinguish between ‘stock’ and ‘flow’ in respect of inflation, too. ‘Stock’ refers to the prevailing level of prices and ‘flow’ to inflation. It is no consolation to the average consumer that inflation gets reduced if there is no change in the high level of prices, which he cannot afford.

If one were to cure the economy of the stock problem, the policy should aim at deflation, not disinflation. But deflation should not have the same unsavoury connotation that it has in the West.

Take the example of housing. How many can afford even a small apartment in a city such as Mumbai when prices have shot through the roof? Will a 5 per cent inflation in the price be helpful when it is Rs 50 lakh?

What can monetary policy do to tackle this price rise, except to raise the interest rate to discourage demand for housing, which would be contrary to the objective of growth? How does it help a consumer if a kg of ginger costs Rs 250, as it was at the height of inflation last year, even if there is zero inflation?

These are not isolated instances of high prices. What is required is administrative action on the part of the government to have a policy that encourages output on a mass scale.

Regulatory Uncertainties

In his classic work, Risk, Uncertainty and Profit , Frank Knight distinguished between the first two. Ignoring the considerable debate on the subject, it is generally agreed that the main difference is that while risk is measurable in a probabilistic manner, uncertainty is not.

Individuals and entrepreneurs can cope with risk by taking pre-emptive measures through such techniques as insurance and hedging. But uncertainty is like groping in the dark to locate an object.

Among the problems faced today by investors and businessmen — Indian and foreign — are policy and regulatory uncertainties. Will there be a delivery of the promised economic reforms to spur growth?

The UPA II government has rolled back even more policy measures than Mr Yashwant Sinha, Finance Minister in the Vajpayee government, who was derisively called “Rollback Sinha”. This policy paralysis affects investors and entrepreneurs adversely.

Another source of anxiety to them is the uncertainty over the type of regulation the government might introduce, which could impact their incomes.

What is observed in the US and the Netherlands due to regulatory uncertainties, according to an article in The Economist (June 15, 2012), is happening in India too, especially after the Vodafone case and the retrospective taxation of deals completed long back.

The uncertainty has wide ramifications for growth, balance of payments and monetary policy, over which the central bank has no control. It is not surprising that many companies are sitting on cash piles as they do not want to take any risk in investment.

(The author is a Mumbai-based economic consultant >blfeedback@thehindu.co.in )

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