Increasing the efficacy of monetary policy

If interest rates aren't reduced quickly & in good measure, the economy will continue to struggle

Another inflation data point has been released with the inflation rate climbing once again. And as expected, commentators are invoking the “stagflation” ghost. Meanwhile, the Reserve Bank of India (RBI) continues to chase completely dissonant monetary policy goals, intervening to weaken the rupee even as they maintain a high level of real interest rates.
 
Monetary policy, especially when operating through the interest rate mechanism, cannot address inflation emerging from consumption items in which demand is either price inelastic and/or interest rate inelastic. Consumption of these items is also called non-discretionary consumption because these items typically include only necessities. Any change in prices of these can cause brief deviations from their trend demand patterns, but not a change in the trend itself. As would be obvious, changes in interest rates do not have much of an impact on the consumption of these items. As such, it is unusual for monetary policy to respond to changes in the price of these items because, well, it can’t do much about it. Higher interest rates do not have an impact on the demand for food and retail consumption of electricity.

 
This is precisely the reason why another measure of inflation exists, called core inflation, which refers broadly to discretionary items of consumption only. Demand for these items responds to changes in price as well as interest rates and the effectiveness of monetary policy in an economy depends largely on how large the proportion of this consumption basket is. In richer economies, discretionary consumption is a dominant portion of the consumption basket and expenditure on food and energy is quite small. In poorer economies a bulk of the consumption is of necessities, leaving very little for discretionary consumption. As such, the efficacy of monetary policy in an economy increases with its per capita income. This is usually visible in the way changes in policy rates are transmitted across the economy. As would be expected at our current per capita national income, transmission in India is far from perfect with long lags and frequent dissonance. 

 

Coming back to interest rates, if inflation is caused largely by non-discretionary items of consumption, it is almost perfectly wrong to respond to it with high rates. This is because a high level of inflation in non-discretionary items is usually disinflationary for discretionary items of consumption. Over short periods of time when income levels are unchanged, a larger share of non-discretionary consumption resulting from higher food or energy prices will typically result in discretionary consumption and savings both getting squeezed. The only monetary policy response to this drop in demand for discretionary items of consumption is a lower-than-equilibrium interest rate environment.

 
Which brings us to ideal equilibrium rates. In any monetary policy regime, the ideal level of interest rates is the minimum possible rate given its inflation environment. It is only at this minimum rate that the growth potential of the economy can be fully realised. There is a lot of commentary on the perspective that in an inflation targeting environment, the central bank isn’t responsible for economic growth. This is fallacious because an inflation target doesn’t replace the central bank’s core responsibility of maximising economic growth, just places a constraint on it. The raison d’etre of any central banks remains the pursuit of economic expansion and the only way to achieve this goal in an inflation targeting regime is by keeping interest rates at the minimum possible subject to inflationary constraints.

 
This minimum rate is a function of expected core consumer price index (CPI) inflation. Not headline inflation and certainly not food and energy inflation, but core CPI inflation because as explained earlier, it is the only inflation indicator which is directly influenced by monetary policy. If expected core CPI inflation is near the inflation target, then overnight policy rates (which is the pure risk-free rate in an economy) need to be equal to (or very close to) the target inflation rate. If expected core CPI is higher than the target inflation rate, then policy rates need to higher as well and vice versa.

 
This regime ensures that risk-free assets don’t generate a real rate of return, a phenomenon which severely damages consumption and capital formation. For example, if expected core CPI inflation is at 3.5 per cent and the risk-free rate is at 5 per cent, this means that one can either consume an indicative item now at Rs. 10,000 or invest that amount, get Rs 10,500 after a year and buy the indicative item then, the price of which would have increased to Rs 10,350. In choosing the latter, one gets a risk-free benefit of Rs 150. Obviously, such an environment will result in consumption getting deferred for as long as such an environment exists. Also, if a real rate of return is available on risk-free assets, then capital owners have a reduced incentive to take risks. This hinders the creation of both debt and equity capital by lowering risk preferences and starving the economy of long-term risk bearing capital.

 
As things stand, existing and expected core CPI inflation is close to, even below, the target rate of inflation. And yet, policy rates are significantly higher with the risk-free rate at least 100 bps higher than the inflation target. The results of this environment, though clearly visible, are still being denied vigorously in defense of the current interest rate environment. This will not end well. If interest rates aren’t reduced quickly and in good measure, the Indian economy will continue to struggle. The extent and duration of this struggle is directly proportionate to the time take to reduce rates. Will the RBI step up to the task?

 
The author is an economist and former CEO of Essel Mutual Fund