Overcoming the paucity of tools with RBI

On May 4, the Reserve Bank of India (RBI) raised the repo rate by 0.4 per cent. The main reason was to deal with the consumer price inflation rate, which has now surged to a high of 7.8 per cent. Though the announcement was welcomed from the viewpoint of price stability, there are concerns regarding output and employment in India. Actually a similar story of a trade-off faced by the interest rate policy is playing out in the rest of the world as well. 

It is often argued that we have to live with such a policy as there is no alternative. This is not true. I will show that we can have a significantly better policy. But before this, it is important to understand the prevailing policy over an entire cycle in the real economy. For simplicity, consider two phases — one of slowdown and the other of boom.

Under the prevailing policy regime, when we have a slowdown, the RBI reduces the interest rates. So the interest costs fall for the borrowers. We may say that the RBI gives a quasi-subsidy to the borrowers. Also, it reduces the interest income for savers. We may say that the RBI imposes a quasi-tax on the savers. Clearly, the RBI runs a quasi-tax subsidy scheme when the economy is in a slowdown!

Next, consider a boom. The RBI is supposed to raise the interest rates. Then there is a quasi-tax for the borrowers as their interest cost is increased, and there is a quasi-subsidy for the savers as their interest income is raised. So, in a boom also the RBI runs a quasi-tax subsidy scheme, though it is the opposite of that in a slowdown.

Under the prevailing policy regime, a reduction in the interest rates is implemented through an increase in the quantity of central bank money relative to its normal path. Similarly, an increase in the interest rates is brought about through a decrease in the quantity of that money. Clearly, the one basic policy tool with the RBI is a change in the quantity of its money. The one basic policy tool is not a change in the interest rate; that is an interim target, while inflation and output are the final targets. All this is the case under the prevailing policy regime.

We can now come to the policy regime that is proposed here. The basic suggestion is that we shift from a quasi-tax subsidy scheme by the RBI to a clear tax subsidy scheme by an autonomous institution associated with the Ministry of Finance (MoF). Let me simplify and say that it is run by the MoF itself.

Under the proposed policy regime, the MoF can give a clear subsidy to reduce the interest cost in order to encourage real investment in a slowdown. This amounts to a reduction in the effective interest rate in a slowdown. And, in a boom, the MoF can do the opposite. This policy of the MoF over an economic cycle to stabilise real investment and output paves the way for the RBI to focus on using its main policy tool, viz. the central bank money for targeting inflation. There is then hardly any trade-off in policy. 

Under the prevailing policy regime, there is one policy tool with the central bank to deal with two variables, viz., inflation and output. In contrast, under the proposed policy regime, we have two policy tools — one with the central bank and the other with the MoF. This is how we can shift from a serious trade-off to hardly any trade-off in policy. This is not all.

The prevailing interest rate policy is blunt. While the objective of the interest rate policy is macroeconomic stability, it has side-effects. The RBI lowers interest incomes for “the middle class” at a time when the economy is in a slowdown, thereby aggravating their difficulties. Also, the RBI adversely affects asset price stability. It (ceteris paribus) pushes up stock prices when it lowers interest rates and it pulls down stock prices when it raises interest rates (the BSE Sensex fell substantially after the interest rate hike this month).

The proposed policy regime may seem a bit strange to some readers. However, it is, in fact, only appropriate that the RBI should run what may be called the pure monetary policy, and the MoF should run a tax-subsidy scheme. What is actually strange is that under the prevailing policy regime the central bank uses what is effectively a tax-subsidy scheme. Why it has prevailed for so long is an important question in the history of economic thought. 

I have simplified here and abstracted from several other related issues. But a more general analysis too has been carried out in my forthcoming book —Thinking Afresh on Macro-financial Stability.

The writer is visiting faculty at the Indian Statistical Institute, Delhi Centre