For the past few months, I have found myself in a tiny minority of commentators who have made a case for a measured approach to monetary policy rather than a full-on assault on inflation. Dismissed as a bunch of misguided cranks, we have been accused of defending a central bank that has fallen hopelessly behind the curve in its interest rate stance. Our critics have argued that since the only reason for a soft monetary regime could be to support the hefty government borrowing programme, we were de facto endorsing fiscal dominance in policy-setting, thus setting the clock back on the RBI’s independence from the finance ministry by a couple of decades.
Hopefully, the events in Europe and its impact on the Indian financial markets have strengthened our case — that RBI should continue to exercise restraint in exercising its policy options — a little. In more specific terms, our counsel, for what its worth, is that RBI should not even think of hiking rates before the July monetary policy whether or not headline inflation remains close to the double-digit mark. Whether it chooses to move in July should again depend on how global and local events pan out over the next two months; not by the dogma of “normalising” rates or trying to catch up with the “curve”.
To explain this, let me do a quick recap of what the contrarian position has been. There are two strands in our argument. The first is based on our assessment on the economic recovery. Despite the unexpectedly solid growth in the index of industrial production (IIP), we have remained somewhat sceptical about the strength and breadth of the recovery. Some of us have used alternative “markers” of economic activity, such as credit growth, to conclude that industrial recovery was still somewhat tentative and confined to a handful of sectors. Others have looked at the nuances of the industrial index itself to show that the devil indeed lay in the detail. The spectacular growth in the capital goods sub-index since December, for instance, was driven largely by traction in truck sales and not by a rise in investment activity. Trucks, referred to in the argot of government statisticians as transport equipment, are part of the capital goods index.
Our second and more fundamental argument is that the series of financial crisis beginning with the subprime crisis in the US mortgage markets have underscored the fact that price stability alone does not guarantee financial stability. It is important to remember that these crises struck during a period of relative price stability. To take an example, US inflation in the 12 months leading up to October 2007, when the subprime problem really broke, averaged a tame 2.3 per cent.
If there is indeed a lesson in all this for monetary authorities, it is that financial stability has to be pursued as an independent objective. It is not an automatic corollary of price stability. I would argue that at this stage there are several threats to financial stability that should get as much attention as price stability. In the case of emerging markets like India, these would manifest in “sudden stops” in external capital flows. This could manifest in a severe drain on domestic liquidity as portfolio flows reverse, and also in reduced access to global capital (ECBs, for instance) as investors and lenders price in enhanced risk perception. The sole policy defence against this, I would argue, from RBI’s perspective is to keep signal rates and domestic liquidity relatively easy.
Can we assume that a resolution of the crisis in Europe will lead to a period of sustained stability for the financial markets? Perhaps not. It is unlikely that Europe’s problems will go away in a hurry. We are not talking of a one-off default here by a small sovereign borrower that an IMF bailout can tide over. The very existence of the continent’s currency union is under a cloud and it will take a few months, if not years, for a satisfactory resolution. Thus, any period of apparent stability in the region is likely to be followed by a period of extreme volatility. All central banks, including RBI, will have to watch that space closely.
There are other pockets where the next financial crisis could rear its head. Events in Europe might have forced us to take our eyes off China but there seems to be a rapidly growing number of analysts who seem to believe that the epicentre of the next shock will lie there. As China tries harder to cool its overheated asset markets down and asset prices (particularly house prices) indeed crumble, it could set off another wave of panic. Then there’s the prospect of the US Fed finally withdrawing liquidity through open market. The effect on financial markets across the globe, currently bloated on a steady swill of cheap liquidity, remains to be seen.
In short, the global financial environment remains extremely uncertain and the domestic economic recovery is at best tentative. In a situation like this, the “optimal” course of action for RBI would be to tread extremely cautiously along the monetary path, whether or not inflation remains high for a few more months and industrial growth prints in double digits.
Were RBI to be bound by the dharma of inflation-targeting, such a stance might seem like sheer apostasy, given the elevated level of headline inflation. But surely the world has changed dramatically in the last two years. In this new world, a more broad-based approach to monetary policy (instead of the dogma price stability at any cost) will and ought to emerge as the new canon. Despite the flak it has come under in the past few months for being soft on inflation, RBI seems to have embraced this new canon. Bravo!
The author is Chief Economist, HDFC Bank. The views expressed are personal
