Subir Gokarn: In search of the neutral zone

The RBI's actions suggest some notion of neutrality.

These last few quarters have demonstrated just how difficult it is to execute monetary policy in an open economy. First, the attempts by the Reserve Bank of India (RBI) to pull in the reins by successive hikes in the repo rate were simply overwhelmed by the flood of capital inflow. Then, when the central bank decided to stop absorbing the inflow, the rupee surged, catching off guard businesses that do substantial billing in dollars. While the debate on what the best policy response is under these circumstances goes on, these developments have generally contributed to an all-round increase in uncertainty, both about the environment itself and about how the RBI will react to specific developments.

One need that emerges from these circumstances is a relatively unambiguous statement from the central bank on what it considers a viable macroeconomic equilibrium. Expressed in terms of ranges for a set of macroeconomic indicators, this essentially lays out a set of conditions under which the bank will not effect any changes in its policy instruments""a "neutral zone". The objective of defining such a zone is obviously to minimise the second source of uncertainty.

In recent interactions with the media, RBI Governor Dr Y V Reddy has appeared to question the merits of the concept, primarily because it is so difficult to specify, particularly in a rapidly evolving economy. The underlying concern is that different circumstances may yield similar outcomes; policy responses may be warranted in some but not in others. An explicitly defined neutral zone may unnecessarily tie the bank's hands in such situations.

That may well be, but a look back over the last period during which the RBI had been raising interest rates does suggest that some notion of neutrality is implicit in its actions. For example, the term "overheating", which has figured prominently in several announcements, only has meaning with reference to some benchmark of normality. Further, this benchmark itself appears to be communicated in the quarterly assessments of the state of the economy.

Focusing on the expectations of the GDP growth rate and the inflation rate, as measured by the Wholesale Price Index, the estimates for the year have typically been lower than what has been revealed by subsequent data releases. In the case of growth expectations, there have been periodic upward revisions, but even these have been lower than the realised numbers. What makes this systematic under-prediction significant is that it seems to be a relatively accurate predictor of policy responses.

In other words, when the growth and inflation numbers have overshot expectations, the RBI has typically acted. This suggests that the expectations are not merely descriptive. They also have a normative element"""what ought to be". And, if the relevant indicators are not what they ought to be, a policy response appears almost inevitable. To my mind, this is consistent with the definition of a neutral zone proposed above.

As the pattern becomes stronger, it will inevitably help markets anticipate the central bank's responses to new macroeconomic data and, thereby, address the issue of policy uncertainty to some extent. However, there are several ways in which the signalling, and consequently, the effectiveness of policy can potentially be improved. In effect, this involves an explicit specification of the neutral zone, in terms of both the indicators and their normative ranges. In today's context, it also involves an identification of indicators that will not be part of the neutral zone, but more on that later.

There are three components involved in the fleshing out of the zone. The first is the "paradigm". What is the theoretical framework underpinning the actions of the central bank? Most observers of the RBI's actions over the last decade would probably agree with the assessment that it has broadly followed the monetarist approach, which postulates a temporary relationship between money supply and GDP growth, thus reinforcing the predominantly inflation-fighting role of monetary policy. Once can understand the reluctance of central banks under most circumstances to tie themselves to any specific paradigm, but it would be desirable for the bank to articulate its prevailing position on the key relationships on which the effectiveness of its policy measures depends.

The second component is the distinction between long-term and short-term factors. In particular, if the operational paradigm is based on a temporary relationship between money supply and GDP growth, the trend rate of growth of the economy can obviously be determined independently of the monetary scenario. That rate, in fact, should be the benchmark against which the current performance of the economy should be judged""overheating if above, not if below. We all have opinions on what the trend is, but do we take the RBI's quarterly statements as an indication of what it believes is the trend? Its actions suggest that we do, but its belief is not formally articulated.

There is no question that an accurate estimation of the trend is an analytical challenge in a rapidly changing environment. But, that does not detract from the need for this benchmark, deviations from which signal the need for corrective action. The best estimates available at the moment can and should be used for purposes of defining the neutral zone.

The third component is the specification of the short-term objective. Assuming that it is, indeed, control of inflation, the appropriate question to be asked is: what is the lowest rate of inflation consistent with the trend rate of growth? Again, this is an analytical challenge in a rapidly mutating economy, but the best analysis available at the moment should provide a usable answer. Once this is established, the overall monetary policy objective can be stated as thus: minimise deviations on both sides of the trend growth path, along with the gap between the potential and actual inflation rate.

Finally, in defining an effective neutral zone, it is equally important to specify what it does not include. The overwhelming perception that the RBI would resist rupee appreciation effectively placed the exchange rate squarely within the neutral zone. This generated the inevitable moral hazard, with people refusing to protect themselves against the risk of currency movements. Whether the exchange rate should be managed or not is a separate discussion. However, with reference to the concept of a neutral zone, all that matters is whether this, or any other, indicator is included or not.

The author is chief economist, Crisil. The views here are personal