| Is the RBI being irrationally exuberant about growth, inflation, and asset prices? |
| The recent decision by the RBI to hike the cash reserve ratio (CRR) by 50 basis points, following up on its tightening by 100 basis points in the short-term rates over the last 12 months, is somewhat surprising (inexplicable?). The rationale: a concern that inflation was getting out of hand; second, that the economy was overheated; third, that by effectively raising short-term rates by 50 to 75 basis points, foreign dollar inflow might be arrested. (Just the opposite""higher real rates in India will mean more capital coming in.) There were additional reasons as well: a perceived "bubble" in asset prices""the Sensex at 14,000 and property inflation in selected pockets, especially in the RBI's own backyard, Mumbai. On the surface, seemingly good reasons; in reality, most likely the RBI has practised "rear window" economics. Stated explicitly, this policy is a boo-boo. |
| But the RBI is in good company. There was Governor Mieno of Japan, who tightened monetary policy in the early nineties as a deflationary measure, despite the fact that the yen had appreciated by more than 50 per cent. An economy that was growing at 3-5 per cent was soon waddling between 0 and 1 per cent. Alan Greenspan raised interest rates by 50 basis points in January 1995, only a month after the Latin American region was in a financial crisis following the Mexican devaluation. The US growth collapsed to only 2.4 per cent after having grown at 4.1 per cent the previous year. Just six months after this bold Fed move to counter excess liquidity, an over-heated economy and asset price inflation (sounds familiar), Greenspan changed course just six months later when he decreased rates by 25 basis points! |
| Greenspan is of course more well-known for his other boo-boo: "irrational exuberance". His observation came in December 1996, when the Dow was 6,400. That comment was meant to jawbone investors into selling stocks. Interestingly, unlike our own RBI, he did not raise interest rates when faced with this exuberant asset inflation. Today, the Dow is more than twice that level, and more interestingly never visited that 6,400 level since the "irrational" statement. |
| Coincidentally following upon Greenspan's ill-fated hike of January 1995, our own RBI also embarked on a tightening spree, actions which were to submerge Indian industry, and growth, for the next seven years. Money supply growth was to average 14 per cent in 1995 and 3 per cent in 1996. Call money rates peaked at 35 per cent in November 1995. In keeping with trends in global inflation, manufacturing inflation in India declined to an average of 4 per cent during 1996-2000. But a high and higher real interest rate regime caused a large part for the Indian economy to grow at several percentage points below potential. |
| There are several other examples of central bankers thinking either that they know better and/or can control events in an increasingly globalised world. The bankers are liable to be wrong particularly when the objective is to control asset price inflation. Professional asset managers are equally confused about markets, but they are more humble. |
| But what is the evidence that the recent RBI action will make it a member of the Monetary Hall of Infamy? According to various you-name-it indicators of growth and inflation, the RBI CRR policy was an ill-suited response to the perceived threat of overheating and/or higher inflation""an "error". (In quotes because the RBI can always claim that it acted with just cause, regardless of what happens. The central bank, unlike the Indian cricket team, almost always wins the policy toss: Tails it wins, heads you lose.) |
| Monetary policy has to be forward-looking and anticipatory of both global and domestic trends. Overheating implies an above normal trend""what is the evidence this is so in either growth or prices? Global growth: the best-case scenario is for stable growth, a likely scenario is that world growth will slow down because of a slowing US economy (GDP growth down to 2.2 per cent, Q3 vs. 5.6 per cent, Q1). US housing is undergoing a large correction. The housing index in the US has declined by 50 per cent from its peak in 2005. |
| Domestic growth: the Indian economy most likely is in the midst of a structural shift. |
| GDP growth is averaging 8 per cent for four years and should no longer be considered a transitory phenomenon. The PM, the Planning Commission, several economists and most analysts have also concluded the same; maybe the RBI is playing contrarian but it is not prudent for them to go so heavily against the "market". |
| An already present contractionary force in the Indian economy is the rapidly contracting fiscal deficit. Tax revenue is up 30 per cent in the first six months and expected by most observers to stay the pace. Government expenditures have to be approved by Parliament. This government has been more populist trigger happy than most, but even they are running out of time to advocate, and implement, a large increase in expenditures. Our firm Oxus estimates that the fiscal deficit of the Centre will decline from 4.1 per cent last year to only 2.7 per cent in 2006-07; the state deficit will decline from 3.2 to 2.1 per cent. The combined deficit at 4.8 per cent will be among the lowest in our history (the lowest since 1970 being 4.5 per cent in 1975). |
| What about the threat of higher inflation? US core inflation (personal consumption deflator, the preferred Fed measure) has stayed in a small range, 2.1-2.4 per cent; euro area core inflation, 1.4-1.7 per cent range. Energy prices have declined by 20 per cent over the last four months. India: core inflation (GDP deflator excluding agriculture and energy) has been stable at 3.8 to 4.1 per cent. Food prices are up sharply, rising at more than twice this rate. The last time food price inflation was running in double digits (averaging 10 per cent for the year) in 1998, the RBI explicitly refrained from raising interest rates or tightening money supply. The reason then""supply shocks were believed to be transient, an argument very recently mooted by RBI officials as well! Further, the acreage for wheat and rice has increased by 15 per cent, suggesting fewer price measures in the future. Sensex inflation: PEs have kept pace with higher growth. So what is broke? Or what is the RBI seeing that the rest of the blind world isQ not? |
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