Last week’s monetary policy statement, with no change in the interest rates, surprised most forecasters, who were expecting a cut, if only because of the expected slowdown in economic growth. The October Index of Industrial Production numbers released on Friday confirm the slowdown. And, this drop was even before demonetisation or, to use the technically correct expression, withdrawal of “specified bank notes”.
The official statement claims that the decision is “consistent with an accommodative stance of monetary policy in consonance with the objective of achieving consumer price index (CPI) inflation at five percent by Q4 of 2016-17… while supporting growth”. It is difficult to understand how the policy stance can be considered “accommodative” given also the increase in the cash reserve ratio imposed in the interim. As for “supporting growth”, the statement itself has reduced the forecast for the current year from 7.6 per cent to 7.1 per cent. One reason for the downward revision is stated to be “demand compression associated with adverse wealth effects”: One is not quite clear what exactly this means.
One reason for not cutting the interest rate could well have been that the rupee has been under pressure since the demonetisation decision, at one point dipping below Rs 68.50 per dollar. The other side is that the real reason underlying the rupee’s fall was the outflow of foreign portfolio investments from the Indian equity and bond markets — and, if anything, a lowering of the interest rate would have helped stock and bond prices and reduced the scale of outflows: Some analysts are expecting that the outflow of foreign funds from the equity market is likely to continue, even accelerate, in the current month. Another reason is the secular rise of the dollar in global markets in the current quarter.
In the context of monetary policy, another step taken recently was the increase in the ceiling on securities to be issued under the Market Stabilisation Scheme (MSS) from Rs 0.3 trillion to Rs 6 trillion. I am intrigued by the rationale underlying this step. It may be recalled that the MSS was introduced when the central bank was running short of government securities to sell in order to “sterilise” the liquidity created by the purchase of dollars in the market in order to stem the rupee’s appreciation. Right now, the situation is altogether different. The Reserve Bank of India holds government securities in excess of Rs 7 trillion in its books: As the statement itself claims, it has injected liquidity of Rs 1.1 trillion through open-market operations during the fiscal year so far. The current excess liquidity is likely to be a short-term phenomenon arising from demonetisation, which has led to a sharp increase in bank deposits thanks to the deposit of old notes and the limitation on withdrawals. This situation should become normal within the next couple of months and one wonders whether it needed a long-term measure like the huge hike in the MSS.
Such policy-specific issues apart, I recently came across a paper by Olivier Blanchard, the former chief economist of the International Monetary Fund, titled “Do DSGE Models Have a Future?”, published in August by the Peterson Institute for International Economics. DSGE (Dynamic Stochastic General Equilibrium) models are used by most central banks for macroeconomic analysis. The paper criticises the models for the following reasons:
* “They are based on unappealing (unrealistic?) assumptions”;
* “Their standard method of estimation, which is a mix of calibration and Bayesian estimation, is unconvincing”;
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* “The single focus on GDP or GDP growth in many policy discussions is misleading: Distribution effects, or distortions that affect the composition rather than the size of output, or effects of current policies on future rather than current output, may be as important for welfare as effects on current GDP”;
* “DSGE models are bad communication devices”.
One point which Blanchard does not touch upon is the issue raised by Helene Rey of the London Business School. Her research suggests that the “impossible trinity” propounded by Robert Mundell back in 1962 — of a liberal capital account, a fixed exchange rate, and an independent monetary policy — is now outdated. The scale of capital flows in today’s world is such that they have reduced the “trinity” to a “dilemma”: “independent monetary policies are possible if and only if the capital account is managed”.
So a liberal capital account reduces growth, increases income inequality (see The Other Side, August 18), and creates a dilemma for monetary policymakers: and we still persist with it!
The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com