The Reserve Bank of India's mid-quarter monetary policy statement could be a classic case of a message lost in translation. The new RBI governor actually "eased" monetary policy quite considerably by cutting the effective policy rate, the marginal standing facility (MSF) rate, by three quarters of a percentage point. However, he bought some insurance against rising inflation and possible pressure on the rupee by hiking the (currently superfluous) repo rate by a quarter of a percentage point. The markets chose to focus entirely on the hike and chose to ignore the cut. After the brief honeymoon in which he charmed hard-nosed bankers and reincarnated gossip columnists in equal measure, Raghuram Rajan, after his maiden policy, somewhat unintentionally emerged as a much less charming uber-hawk.
One argument is that this biased reading of the market is partly the RBI's fault. Bankers might have understood the barrage of ad hoc measures like the hike in the MSF rate and the cap on repo borrowings when they were announced in mid-July; but, for the larger market and corporate India, they remained a bit of an enigma. This world tends to think of monetary policy in terms of the repo rate and the cash reserve ratio (CRR). Thus, it naturally noticed what it could comprehend in the policy and chose to ignore the rest of the gobbledegook. Only this time, the gobbledegook was just as important. Perhaps the RBI is better off using the conventional tools - the CRR and the repo rate - even in times of an emergency, to avoid needless confusion.
That said, one cannot attribute the adverse reaction to naivety alone - there are deeper concerns and anxieties. For one thing, there is a legitimate concern that the RBI is shifting more formally to consumer price index (CPI) inflation as its target. Even if it chooses to ignore the sharp variations in food or fuel prices, it is possible that it will target core CPI (about 40 per cent of the basket) more closely. Inflation in this core component is running above eight per cent, a good two percentage points above wholesale price inflation. This implies that the repo rate will have to move up a couple of notches to be consistent with this new target. That's bad news for the doves.
The use of core CPI inflation as the target seems logical and consonant with the long-standing demand that the RBI should be in the business of protecting consumer incomes, and should not just be keeping wholesale prices in check. The core CPI also contains the prices of a number of services that the wholesale price index (WPI) misses out completely. Inflation in these services is mostly responsible for the elevation of the index.
I have a couple of caveats to offer. First, targeting core CPI inflation is like starting a whole new ball game. The drastic fall in core WPI inflation, which currently hovers at a little over two per cent, is unlikely to pull core CPI inflation down. I would not be surprised if there is very little correlation between the two. Thus, if core CPI inflation were indeed to emerge the effective target for monetary policy, the gains that the central bank made in decimating the pricing power of manufacturing companies (as measured by the core WPI) could effectively go into the trash can.
The second, and related, problem is that we do not understand the markets for these services too well - the housing rental market, for instance, or the market for medical services. Before we use the sledgehammer of the policy rate or the CRR to curb inflation in these markets, it is important to figure out whether there are chronic, structural supply bottlenecks in these markets. If that were the case, the monetary fight against these sources of inflation could turn out to be a long and somewhat futile battle.
Economic policy making in India, both fiscal and monetary, is currently caught in a "rules versus discretion" debate. As far as monetary policy is concerned, the rule-wallahs seem to be getting the upper hand and argue that the absence of a defined nominal anchor and an associated target, and the lack of accountability in meeting this target, is at the heart of the economy's woes. Their prescription seems to be: adopt a formal inflation anchor and ensure that monetary policy willy-nilly gets to this target.
Let me quote Michael Woodford, perhaps the most influential monetary theorist around today, to identify some of the pitfalls of this approach that the RBI should do well to avoid: "I think it is important to stress that inflation targeting need not mean and should not mean the caricature of it that one sometimes hears, according to which inflation targeting should mean making inflation control the sole objective of policy at all times, on the view that inflation stabilisation will by itself be sufficient to guarantee macroeconomic stability."
I would argue that in the current situation, where the link between growth and headline inflation has been severed completely, the RBI needs to retain some discretion in giving growth a boost. This "tactical" approach to monetary policy - taking advantage of some encouraging directional trends (and not just levels) in headline inflation or some of its critical components like core inflation, to give the economy some relief on its interest costs - is essential at this stage. Otherwise, even if the government were to "clear" projects and sort out problems such as crippling environmental regulations, private capital expenditure would still not recover.
The RBI could find the middle ground between rules and discretion by building both growth and inflation into the central bank's short-term nominal target. Professor Woodford has been arguing for nominal GDP as a target; in India's case, this would help in handling episodes where growth collapses but inflation remains sticky. The argument that GDP is unreliable and prone to revision doesn't quite wash with me. We use the same GDP to gauge growth and set all sorts of fiscal and monetary targets.
We have an "out-of-the-box" problem on our hands and it needs an "out-of-the-box solution", not something out of an antiquated textbook.
The writer is with HDFC Bank.
These views are personal
These views are personal
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
