Monetary Policy in India: Does the RBI Have a Framework?

There has been mounting criticism that the RBI is not doing enough to promote growth by lowering interest rates. In addition, India’s trade deficit has reached levels not seen for some time, and the rupee is in a free fall – its depreciation this year against the US dollar had exceeded those of other Asian currencies (before the Turkish crisis).

So, is the RBI conducting monetary policy in an optimal fashion? If not, what is missing? To answer these questions, one has to organise one’s thoughts keeping two things in mind.

First, what should be the broad framework of macroeconomics that should guide the RBI’s policies?

And second, this framework has to incorporate the structural features of the Indian economy. That is, we require some input from economic theory but embed into it the relevant local institutional features.

Traditionally, macroeconomic policies (i.e. monetary and fiscal policies) were supposed to try and attain internal balance (i.e. full employment, low inflation etc.) and external balance (i.e. current account deficits should be manageable).

This list of targets should have included a healthy financial system but until recently, even in the advanced capital countries, financial markets were so regulated that the issues of bank failures etc. were not on the policymakers’ radar. Only with financial deregulation, national and international, has the issue of financial stability become a source of major headache for the central banks. In this piece I will not dwell on this important aspect of monetary policy, because it encompasses areas beyond traditional macroeconomic policies.

Stabilisation policies in the advanced capitalist countries are the intellectual offspring of Keynes’ General Theory. They were put in place after World War II. From the end of the War to the first oil price shock in the mid-1970s, we had the golden age of capitalism. It was difficult not to agree with Harold Macmillan when he said of the period: “we never had it so good“. Monetary and fiscal policies were used to ensure full employment; and incomes policies (wage restraints) ensured inflation remained within bounds. The oil price shock of the 1970s was to end the good times. Inflation rose while output fell – a supply shock that demand management policies were ill-suited to cope with. There was now a hard choice – either you stabilise output, thereby feeding inflation further, or accept a reduced output to keep inflation in check.

With this, the intellectual tide also turned against intervention and mainstream macroeconomics lurched to the right. Milton Friedman and his intellectual acolytes asserted that for the advanced economies, the markets restore full employment (christened “the natural rate of employment“) and fiscal and monetary policies were unnecessary. The only question was the speed at which equilibrium was restored.

Since there was precious little that macro policies could do to lower unemployment below this full employment level, monetary policy should be concerned with keeping prices (or the rate of inflation) stable (one of Friedman’s famous quotes: “inflation is everywhere a monetary phenomenon”). While Friedman’s thinking continues to dominate mainstream macroeconomics, his passionate advocacy of controlling “the” money supply has quietly been jettisoned (mainly because financial innovation caused a breakdown in a hitherto stable relationship between the money stock and prices). Inflation targeting became the preferred policy.

Now, fiscal policy was rarely used, certainly not by those economies that were saddled with large public debts because debt sustainability issues kept profligacy in check. Monetary policy also did not pay attention to unemployment and only tried to keep inflation in check. Policymakers also did not need to concern themselves with external balance in the advanced capitalist countries. This was because their currencies are fully convertible and there are no impediments to capital flows – the market determines the exchange rate. Any current account deficit can be financed by issuing (internationally acceptable) debt.

Thus, full employment and external balance were essentially dropped from the policy menu. Inflation targeting meant only if the inflation target was not a constraint, could the monetary authorities engage in “unconventional” monetary policy (as they have in most OECD countries in the last decade).

A corollary to the capitulation by mainstream macroeconomics to Milton Friedman’s thinking was that if the market produces full employment, then in the making of policy, politicians must not be allowed to interfere with the market mechanism. Policy rules must be transparent, so that the private sector can factor these into their decision making process. These matters should be left to technocrats (who presumably stand outside the murkiness that is society). Of course, it is true that politicians can play havoc with the economy (e.g. think of the Indian demonetisation exercise), But what about the technocrats manning independent central banks (e.g. again the Indian demonetisation exercise – they did not cover themselves with glory)?

We will come back to this below. The RBI’s monetary policy framework, that is flawed in more ways than one, tries to fix rules about the RBI’s preferred inflation rate and the policy stance it will take if it is deviated from. But we have nothing on the external front. The exchange rate can be whatever the RBI thinks is OK but the public does not know it. Does the RBI, having tied itself to the mast of preannounced rules, believe that the exchange rate plays no role in economic decision-making of the private sector?

Before I turn to the nitty-gritty of India’s monetary policy, let me point out even if (and that is a very big if) the assertion that markets work is true of the advanced capitalist countries, it is surely a bit rich to say markets work in developing countries. Markets may not exist; if they do, then they are thin. If proof is required compare any macroeconomic time series of a poor country with that of any rich country – the former will show more volatility.

Tolstoy had said that all happy families are the same, but unhappy families are unhappy in their unique ways. In terms of its economy, India is quite unique, even among developing countries. Only China has a population of a comparable size. Before it took off, it was also similar to India in terms of per capita income. China, however, has pulled itself out of poverty and is an economic (and political) power to reckon with, whereas India, notwithstanding delusions of grandeur, is nowhere in the picture.

In discussing the conduct of macroeconomic policy in India, it would be important to bear in mind some of the salient features of the Indian economy.

About 60% (if not quite 60, certainly above 50%) of the workforce is employed in agriculture that produces about 15% percent of its GDP. This is a classic case of marginal productivity in agriculture being close to zero; the underemployed labour is crying out for alternative avenues of employment. Agriculture is also becoming a very risky enterprise. Apart from the fragmentation of landholdings, there is excessive use of pesticides that cause resistance from the worms that the pesticides were intended to get rid of. And then there is climate change with erratic rainfall (sometimes giving large parts of the country a miss and, at other times, causing floods) and rising temperatures. And this is only a partial list of woes facing Indian agriculture. But it will do for our analysis. From a macroeconomic perspective, a failure of the monsoon constitutes a (negative) supply shock. The effect of this is to lower output (GDP) and raise the price “level”. It is not dissimilar in its effect from a rise in the price of imported crude, except that the first round fall in income hits a large proportion of the labour force.

The RBI has gone in for a regime of inflation targeting. Why? That is not clear but it seems to be following the “best-practices” internationally – this is a euphemism for following what is fashionable. Inflation targeting is supposed to be the “savior of the human race”, no doubt because it has “proved efficacious in every case”! Notwithstanding the fact that agriculture looms large on the Indian economy and that with specific problems confronting that sector, there is very little that monetary policy can do. But the RBI’s Committee (chaired by Urjit Patel, when he was peputy governor) recommended moving to a CPI-based inflation targeting framework. The report was a cut-and-paste job. The inflationary process in India, we are told, can be represented by a Calvo-type New Keynesian Phillips Curve without providing a shred of evidence in support. This modelling of the Indian economy and the objective of monetary policy by the RBI makes no sense. I thought selecting the monetary policy framework for a complicated developing economy required debate and by no means was such a doddle. Evidently, not everyone agrees with me!

The prototype inflation targeting model has some price inflexibility and unemployment in the transition to the natural rate (the Calvo Phillips’ Curve mentioned above). If inflation is above the Central Bank’s desired rate, demand compression via the Taylor Rule (nominal interest is raised by more than the increase in inflation, so that the real rate of interest rises) will lower it. In principle, nothing prevents the Central Bank from also “looking at” the current level of unemployment compared to the natural rate. In fact a number of developing countries do, and call it “inflation targeting plus”.

There is another big problem, viz., unlike in the advanced economies, it is not the case that the exchange rate is determined by the market and that external balance is not a problem. All developing economies with open capital accounts are worried about capital flows—inflows and outflows both cause (different) problems. India’s capital account is not fully open, so any change in the interest rate that the RBI’s policy entails (e.g. in fighting inflation) has implications for capital flows.

And that is exactly what has happened in India. Ever since the adoption of the inflation targeting framework, the Monetary Policy Committee has been reluctant to lower interest rates because these are not warranted by India’s inflation profile. Since 2014 the world price of our crude oil imports have been low (these have started to climb recently), so the inflationary pressures have been home-grown. If oil prices continue to rise (as they have started to this year) then the effects of domestic supply shocks will be magnified. Given the inflation targeting objective, the RBI raised interest rates (by more than the increase inflation) to compress aggregate demand. But even if demand was not interest sensitive and this channel is not operational (e.g. because business is pessimistic about future sales and does not want to borrow), the rise in the interest rate caused a capital inflows and an appreciation of the currency (remember OECD interest rates were close to zero).

Demand for the domestic output (our exports) fell and a larger trade balance deficit ensued. Capital inflows were self-perpetuating because not only was the Indian interest rate high, it was accompanied by an appreciating exchange rate (that made investment in Indian financial assets even more attractive from a foreigner’s perspective). Of course, these “carry trades” do not last forever. Any rise in the foreign interest or the price of imported crude or Trump’s erratic behavior will turn off the music and end the party. Suddenly we will realize that the tap of capital inflows that helped us ignore current account deficits has been turned off. This will cause a depreciation of the exchange rate. Anyone holding rupee-denominated financial assets will be hit. Note the nominal exchange rate will have to depreciate quite a lot to shed the accumulated real appreciation (the real appreciation was about twenty percent in the last ten years). The real depreciation that follows will cause a lot of pain to the Indian rich, who consume foreign goods, send their children to study abroad and borrow (unhedged) in foreign currency. And this is just the adjustment required to balance the books. We are not discussing the role of a real appreciation in killing off the (unborn) labour-intensive manufacturing sector.

There are rules cast in stone for the RBI to follow when inflation rises (because of inflation targeting). But are there rules about the exchange rate? As capital outflows occur, the RBI can sell dollars to slow the depreciation of the rupee. But what is the rule? If monetary policy is going to be transparent, why is there so much of communicating with the private sector on inflation but a resounding silence on issues
relating to the depreciation exchange rate and falling foreign exchange reserves. The RBI’s statement that they intervene to manage volatility is an eye-wash. Today, even God does not know what is the trend of the nominal exchange rate path, and what is its volatility (of course, that does not prevent the RBI Governor from knowing it!).

Another red herring should be disposed off here. It is repeatedly argued by commentators (including our part-time Finance Minister) that India has sufficient foreign exchange to meet any exigency. Maybe, but keep two things in mind: first, a capital outflow can make $ 400 billion of foreign exchange disappear very quickly; second, India’s foreign exchange reserves are acquired through (sterilized) intervention—there are liabilities against them (contrast this with China buying off all of India’s South Asian allies with foreign exchange that they own!).

The analytical problem is therefore compounded by keeping the domestic economic activity and the links with the rest of the world in separate water-tight compartments (see e.g. the Urjit Patel Committee Report and a Brookings India paper by Rakesh Mohan and Partha Ray; an exception is Vijay Joshi’s L.K. Jha Lecture at the RBI). The international dimension of the consequences of raising interest rates is an afterthought. This is no doubt inherited from American textbooks on macroeconomics where the entire analysis is conducted for a closed economy with the last chapters “opening up” the economy. The country could be taken to the cleaners because of our policy-makers’ inability to think beyond US (undergraduate) textbooks.

The open economy dimensions are treated in a cavalier manner. For instance, the previous finance minister (UPA 2) repeatedly told the Parliament about how the current account was a problem and always got the definition of current account wrong (for him, undoubtedly, the current account was a problem!). The present government’s Principal Economic Advisor says (with ba straight face) that over the longer run, the ministry looks at real exchange rates. And pray what do you do when you find a problem?  What policy arrows do you have in quiver to tackle the 20% overvaluation?

It is, of course, true as the Prussian General von Moltke (Bismarck’s Chief of Staff) said “No battle plan survives the first contact with the enemy”. I do not think that was meant as a carte blanche for going into battle completely unprepared.

Partha Sen is retired professor of Economics, Delhi School of Economics.