Thrown off guard by monetary policy?

A question worth asking is: How predictable should monetary policy be? If one looks at the Federal Reserve providing direction, it is clear that rates will only go up, and the scope for conjecture is restricted to the ‘when’ of it. In fact, indications are that the quantum or rise would also be gradual — 25 bps at a time.

The European Central Bank (ECB) says that it will do everything to provide liquidity to the system, and one can be sure that rates will remain where they are. In our case, the Reserve Bank of India has blown hot and cold at different times, taking different actions under similar underlying conditions. Is there a theory behind these actions?

The estern world follows the monetarist school propagated by Milton Friedman, who argued that inflation everywhere was a monetary phenomenon. Hence, if inflation had to be controlled, then monetary policy would have to be circumspect.

The movement in the inflation rate juxtaposed against the target stated by the central bank would provide a clue as to whether or not there would be rate action. The Fed’s lower bound of 2 per cent for inflation has become important today.

A corollary to this monetarist tenet is that monetary policy cannot really bring about growth, which in a way is true. Even with the world bringing interest rates close to zero or even negative as in the case of the ECB, growth has not picked up.

An explanation for this is the famous liquidity trap, where demand for money has declined to such an extent that lowering rates or even providing liquidity has not helped except at the margin.

The excess liquidity has flowed into emerging markets as foreign portfolio flows. This has generated volatility in emerging market currencies, requiring remedial action from the respective monetary authorities.

Friedman spoke of the natural rate of unemployment, which ranges between 4-6 per cent in the western world.

 The Indian path appears to tilt more towards the ‘rational expectations’ hypothesis made popular by John Muth and later by Robert Lucas and Thomas Sargent. They argued that monetary policy cannot influence economic activity if the goals are stated clearly and the central bank pursues them to the hilt. This, in their view, also holds true for fiscal policy.

The only way it can work effectively is when the central bank manages to successfully ‘fool’ the market. By ‘fooling’ the market it means that if the central bank says one thing and does another, it can have an economic impact.

This is because economic agents would have acted on the basis of the central bank’s statements.

In simple terms, if an impression is given that the RBI is going to lower rates, or such a perception builds up, then the RBI can be effective by not lowering rates, thus bringing about the desired change, that is, quelling inflationary expectations. 

In the last three policies of the RBI in 2015-16, interest rates were lowered once and left unchanged on two occasions. The factors that could have influenced monetary policy did not change: low current inflation, higher inflationary expectations, uncertain rupee, ambivalence regarding Fed rate hike and global volatility. Yet, the response was different.

 Whenever a policy review comes up, the market develops an expectation on what the RBI will do, and it is said that 25 bps or 50 bps cut has been ‘buffered in’.

This really means that from the market perspective, this quantum of cut does not matter and hence, the G-sec yields begin moving downward in anticipation.

However, if this rate cut is not invoked, the market is shaken and rates start moving in the opposite direction. In such a situation, the central bank would be justified in not doing anything. If it did, it would not have mattered as the market would have been ahead of the curve, anyway.

The related  ‘efficient market hypothesis’ says that markets are efficient in case all participants have access to the same information and make their conjectures accordingly, which leads to an optimal solution. But in this case, the market while trying to guess the central bank’s action would tend to lose out when the RBI does not act according to expectations.

Therefore, a call has to be taken by the central bank on which approach is more acceptable. Providing certainty helps investors take decisions, but this can create macroeconomic distortions. But markets will be less volatile in this scenario. Keeping the markets guessing is effective, but statements made by the central bank are critical as every word is interpreted by economic agents.

They are constantly on the lookout for forward guidance and would expect the central bank to adhere to the same. It’s a question of how the central bank plays its cards.

 For the central bank, it would be more effective to surprise the market with action that may not be consistent with the impression created.

This stance is different from the monetarist approach. But it would be congruent with what Keynes is supposed to have said: “When the facts change, I change my mind. What do you do, sir?”

The writer is chief economist at Care Ratings. The views are personal 

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