As you will understand from all that I have been saying, monetary policy under an inflation-focused framework tries to balance various interests as we bring inflation under control. In doing so, we have to have a pragmatic rather than a doctrinaire mindset. For example, emerging markets can experience significant capital inflows that can affect exchange rate volatility as well as financial stability. A doctrinaire mindset would adopt a hands-off approach, while the pragmatic mindset would permit intervention to reduce volatility and instability. Nevertheless, the pragmatic mind would also recognise that the best way to obtain exchange rate stability is to bring inflation down to a level commensurate with global inflation.
Similarly, while financial stability considerations are not explicitly in the RBI's objectives, they make their way in because the RBI has to keep growth in mind while controlling inflation. So if the RBI's monetary policies are contributing to a credit or asset price bubble that could lead to a systemic meltdown and growth collapse, the RBI will have to resort to corrective monetary policy if macro-prudential policy alternatives are likely to prove ineffective.
The transition to low inflation
The period when a high inflation economy moves to low inflation is never an easy one. After years of high inflation, the public's expectations of inflation have been slow to adjust downwards. As a result, they have been less willing to adjust their interest expectations downwards. Household financial savings are increasing rapidly as a fraction of overall household savings, but not yet significantly as a fraction of GDP. Some frictions in the interest rate-setting market do not also help. Even while policy rates are down, the rates paid by the government on small savings are significantly higher than bank deposit rates, as are the effective rates on tax-free bonds. I am glad the government has decided to link the rates on small savings to government bond rates, but these rates will continuously have to be examined to ensure they do not form a high floor below which banks cannot cut deposit rates. All in all, bank lending rates have moved down, but not commensurate with policy rate cuts.
The wrong thing to do at such times is to change course. As soon as economic policy becomes painful, clever economists always suggest new unorthodox painless pathways. This is not a problem specific to emerging markets, but becomes especially acute since every emerging market thinks it is unique, and the laws of economics operate differently here. In India, at least we have been consistent. Flipping through a book of cartoons by that great economist, R K Laxman, I found one that indicated the solution for every ill in 1997 when the cartoon was published, as now, is for the RBI to cut interest rates by a hundred basis points. Arguments change, but clever solutions do not.
Decades of studying macroeconomic policy tells me to be very wary of economists who say you can have it all if only you try something out of the box. Argentina, Brazil and Venezuela tried unorthodox policies with depressingly orthodox consequences. Rather than experiment with macro policy, which brings macro risks that our unprotected poor can ill afford, better to be unorthodox on microeconomic policy such as those that define the business and banking environment. Not only do we have less chance of doing damage if we go wrong, but innovative policy may open new paths around old bottlenecks. Specifically, on its part the RBI has been adopting more liberal attitudes towards bank licensing, towards financial inclusion, and towards payment technologies and institutions in order to foster growth.
Institution building
Let me return to institution building. We had gotten used to decades of moderate to high inflation, with industrialists and governments paying negative real interest rates and the burden of the hidden inflation tax falling on the middle class saver and the poor. What is happening today is truly revolutionary - we are abandoning the ways of the past that benefited the few at the expense of the many. As we move towards embedding institutions that result in sustained low inflation and positive real interest rates, this requires all constituencies to make adjustments. For example, if industrialists want significantly lower rates, they have to support efforts to improve loan recovery so that banks and bond markets feel comfortable with low credit spreads. The central and state governments have to continue on the path of fiscal consolidation so that they borrow less and thus spend less on interest payments. Households will have to adjust to lower nominal rates, but must recognise that higher real rates make their savings more productive. They will find it worthwhile to save more to finance the enormous investment needs of the country.
Adjustment is difficult and painful in the short run. We must not get diverted as we build the institutions necessary to secure a low inflation future, especially because we seem to be making headway. The Government has taken the momentous step of both setting a CPI based inflation objective for the RBI as well as a framework for setting up an independent monetary policy committee. In the days ahead, a new governor, as well as the members of the committee will be picked. I am sure they will internalise the frameworks and institutions that have been set up, and should produce a low inflation future for India.
The rewards will be many. Our currency has been stable as investors have gained confidence in our monetary policy goals, and this stability will only improve as we meet our inflation goals. Foreign capital inflows will be more reliable and increase in the longer maturity buckets, including in rupee investments. This will expand the pool of capital available for our banks and corporations. The government will be able to borrow at low rates, and will be able to extend the maturity of its debt. The poor will not suffer disproportionately due to bouts of sharp inflation, and the middle class will not see its savings eroded. All this awaits us as we stay the course. Thank you very much for your patience for listening to me.
Edited excerpts from a speech by Reserve Bank of India Governor Raghuram Rajan at the Tata Institute of Fundamental Research in Mumbai, on June 20
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
