Subir Gokarn: Ways to cool off

The interest rate is the RBI's best bet for keeping the economy close to the 'normality' benchmark.

The Reserve Bank of India's (RBI's) decision to increase the repo rate and the cash reserve ratio (CRR) on March 30 appears to have triggered a significant change in market perceptions about the state of the economy. From euphoria to despair within a week is fast, even by Indian standards of over-reaction. Under the circumstance, it may be useful to look at the RBI's recent actions in terms of a simple framework and evaluate them in terms of some technical criteria.

But, before getting into the evaluations, however, a couple of questions need to be addressed. First, is the economy really overheating or not? Second, even if it is, is it conceivable that monetary constriction can bring down the rate of inflation without actually lowering the growth rate?

On the first issue, while it is reasonable to argue that the current rate of inflation is being significantly driven by the supply situation in many agricultural commodities, one cannot ignore the fact that the prices of manufactured goods are also rising at an annualised rate of around 6 per cent. Whether this is reflective of overheating or not depends, of course, on what the benchmark is. If the benchmark is 2 per cent, then 6 per cent is clearly symptomatic of serious overheating, calling for drastic steps. However, if the benchmark is 5-5.5 per cent, which is what the RBI has been telling us time and again, then 6 per cent represents moderate overheating, amenable to moderate interventions.

Why does the rate of inflation in the prices of manufactured goods indicate overheating? Because, these are typically freely tradable and domestic supply constraints are not a significant driver of price dynamics, unlike in the case of agricultural commodities. Therefore, price increases are more likely to be demand-driven.

On the second question, there is certainly a theoretical scenario in which inflation can be brought down without affecting growth. From a macroeconomic policy perspective, however, the requirements for this scenario, from the way in which consumers and investors anticipate the future to the extreme flexibility of markets, are too rigorous for it to be practical. The bottom line is that, if inflation has to be brought under control by reducing demand, the growth rate will inevitably be lowered.

Once one accepts this inevitability, the objective is to identify the quickest and most painless route to lower inflation""i.e. the strategy which achieves a given reduction in the inflation rate with the smallest decline in the growth rate, along with the minimum adverse impact on any other politically significant indicators. This is, in essence, the soft landing.

We can now look at the four components of demand and match them up with four policy instruments for demand management. To influence domestic consumption, investment, government consumption and exports, the instruments available are the interest rate, the exchange rate, taxes and public expenditures. The optimal matching of instruments to objectives depends on the magnitude, speed and predictability of the relationships, against the backdrop of broader political objectives and priorities.

What is clearly upsetting people who have begun expressing some nervousness about the RBI's approach is that interest rate increases will have their maximum impact on domestic consumption and investment, which have been the most significant contributors to the high growth rates in recent years. Don't kill the goose that lays the golden eggs, they seem to be saying. Why not use another instrument that will work through other channels?

The exchange rate comes to mind. Given that the balance of payments shows a significant surplus, indicating that the supply of foreign exchange to India is greater than the demand for it, why not let market forces work and let foreign exchange become cheaper, which means the rupee will appreciate? This will make imports cheaper and, therefore, more competitive against domestic products, reducing demand and easing pressure on prices at one stroke. It will also make our exports less competitive, reducing demand for our products from the rest of the world.

These are all valid arguments. However, in terms of optimality, two factors need to be considered. One, the external sector is still a relatively small proportion of the economy and, therefore, the impact of an instrument that depends on this channel is likely to be small. Two, and more importantly, our manufactured exports, which are most at risk from a rupee appreciation, are among our most labour-intensive products. Restricting demand by making exports more expensive comes with the likelihood of high job losses, an outcome that will clearly not be acceptable to any government.

Can we, then, look at taxes and public expenditures for the solution? To a large extent, they are already playing a part. Let's remember that the central government's fiscal deficit is close to 3 per cent of GDP and the combined central and states deficit will barely be over 6 per cent in the coming year, a significant decline from the peak of over 10 per cent just a few years ago. And, direct taxes, which will impact private consumption and investment, have been increased by, for example, the education cess. However, the room to play around with taxes is naturally limited by the need for a stable and credible tax regime to facilitate long-term savings and investment decisions.

So, where does that leave us? Essentially, the quickest and most dependable way to rein in demand is to use the instrument that directly influences its most significant components. This takes us back to interest rates and their ability to influence consumption and investment. Whatever policymakers may or may not do with the other instruments, higher interest rates and their consequences on domestic spending are an unavoidable component of an anti-inflation policy.

Yes, the risk of a meltdown if the RBI should go too far exists, but it is tempered by the relatively quick reversibility of the instrument. Small and frequent changes, with relatively predictable effects down the line, are characteristic of the use of this instrument. They are what make it easy to reverse course when the situation warrants.

In short, once the RBI has set a benchmark for macroeconomic "normality", the interest rate is its best bet for keeping the economy close to that benchmark. The markets should neither be surprised by its actions, nor concerned by the risks that they pose to performance. What would constitute a meaningful debate is what the benchmark of normality ought to be.

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