Subir Gokarn: The art of the soft landing

The judicous use of market forces by policymakers has enhanced the capacity of the world economy to land softly.

One metaphor that has entrenched itself in the economic policy discourse is "soft landing". The term is an attractive blend of power and finesse, suggesting the capability of the pilot/policymaker to find a sustainable balance between multiple and often turbulent forces.

Judging from the macroeconomic performance of the global economy over the last two decades, one could reasonably conclude that central bankers have mastered the art. For the world as a whole, the volatility of GDP growth rates and inflation rates appears to have decreased during the period.

Further, perhaps partly as a consequence of increasing stability but also due to other factors, the global economy is able to grow at a more rapid rate for any given rate of inflation (or suffer lower inflation for any given growth rate) than before. Both these outcomes are directly related to how central banks use the instruments at their disposal, in terms of both the magnitude and timing of their actions.

From this perspective, the key attributes of the soft landing approach are pro-activity, gradualism and persistence. Just as a commercial airliner needs a relatively long approach path on which to descend, an economy needs a regular stimulus of moderate but unmistakable signals from the policymaker in order to make adjustments without too much of an upheaval. However, even if central banks have absorbed this lesson, it does not automatically translate into effective monetary policy. Effectiveness is limited or reinforced by the channels by which policy signals are communicated to the economy.

Policy effectiveness has been greatly enhanced in recent decades by the development of financial markets across the globe. Markets amplify small signals from the policymaker quickly and unambiguously, giving consumers and investors the right cues; in turn, this increases the probability of achieving the desired outcome. As a consequence of these developments, most central banks have come to rely almost exclusively on tiny increases or decreases in one instrument, a benchmark interest rate, to influence the decision-making and the activity levels of the entire economy.

Finger-tip control, indeed. Errors of judgment can and will be made but the attractiveness of the approach lies in the fact that, since the changes are small, so are the errors and these can be quickly corrected, avoiding major deviations from the chosen path.

This is a rather long-winded setting of the context in which we should view recent and likely developments on the global macroeconomic stage. The US Federal Reserve recently stopped increasing its primary policy instrument, the federal funds rate, after 17 successive increases. It has stayed at 5.25 per cent for two consecutive committee meetings.

The reasoning behind this change of course is simple. The main indicators that had induced the increases in the first place have now changed to a point where they do not warrant further increases. The soft landing has been achieved. The status quo will, presumably, be maintained until the relevant indicators move out of their current alignment. Of course, the policy response will depend on the direction in which they move, but that is too early to anticipate at this point.

Yes, GDP growth will be a little slower as a consequence of all those interest rate increases. Clearly, however, the decline will be far less than in an alternative scenario in which the interest rate had been allowed to remain low and then raised suddenly and sharply when inflation and other indicators moved out of the acceptable zone.

The point is that a policy-induced slowdown such as we are likely to see over the next few quarters has been anticipated by everybody concerned and does not come as a shock or surprise. As a change of direction is signalled, with equal gradualness and persistence, the response will be equally predictable and moderate. This is what contributes to stability, which in turn reinforces sustainability.

India has begun to follow this path over the last couple of years. As domestic financial markets have become more and more sophisticated, the Reserve Bank of India (RBI) has been able to move away from blunt and unpredictable "quantity" instruments like the cash reserve ratio to more precise and reliable price instruments like the repo and reverse repo rates. Evidence on interest rate movements over the last couple of years suggests that market rates have become more sensitive and responsive to the RBI's benchmark rates.

This strengthens the channel of transmission between the policymaker and the investor and consumer, making the outcome of policy measures more predictable and controllable. In turn, the margin for error is reduced and the ability of the economy to quickly change direction is enhanced. The likely outcome, like in the US, is some moderation of the growth rate for some period of time. A sharp decline in growth , followed by a painful and possibly slow recovery, is highly improbable in the current policy regime.

By contrast, Chinese policymakers have been speaking of a soft landing for more than a couple of years now. In 2004, they stated their intent to bring the growth rate down from close to 10 per cent to, in their view, a more sustainable 7 per cent. Several restrictions on overall spending as well as on investment in specific sectors were announced. None of these has apparently had much impact. Growth continues to barrel along at close to 10 per cent.

Of course, given the magnitude of trade between the US and China, a moderation in growth in the former will inevitably translate into slower growth in the latter, not to mention the rest of Asia. But then, anybody whose business depends on the US market would surely have anticipated this outcome based on what the US Federal Reserve has been doing over the last couple of years.

These expectations have recently manifested into a distinct softening of oil prices. This development actually adds to the self-correcting nature of the process, making the soft landing an even surer thing. Lower oil prices will allow central banks the leeway to at least put a stop to interest rate increases, even start to reduce them under appropriate conditions.

Having come through over three years of rising oil prices with barely a blip on growth and inflation, the global economy has unquestionably developed the capacity to land softly. This is the result of a combination of the financial market development and policymakers' ability to use the power of markets to achieve their objectives. As in several other instances, well-functioning markets are conducive to more effective policymaking.

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