Is it Time to rework our Monetary Policy Framework?

http://www.financialexpress.com/opinion/what-should-rbi-give-weightage-to-decide-policy-rates-all-you-want-to-know/941225/

My article with the title above (different in title between the Print version and e-paper version) appears in Financial Express today.

 

The government seems to be in a bit of bind over both employment and growth, not for all its as own making. One of the chief contributory to this morass is the inappropriate way the objectives of our monetary policy have been fixed or evolved over the last 6-7 years. The Chart shows clearly the increasing misalignment between the inflation, external value of Rupee (as reflected by REER) and the interest rates caused by the recent shifts in our monetary policy. The Chart uses the WPI instead of the new found CPI which is 57% out of control of RBI’s policies as the report itself admits.

Two main components as it operates in our Monetary Policy Framework are (i) to target a consumer price inflation of 4% with a tolerance of 2%. Both the variable and its levels are recent developments, and (ii) to aim at orderly conduct of the forex markets without seeking to target any particular rates.

Fundamental flaws

Firstly, in both these, the targets are fixed without reference to any end goals in mind. As if these are desirable self-actualising end-goals in themselves. In economics everything is interconnected – inflation, interest rates, growth, employment, productivity, cost competitiveness, etc. To seek a deterministic nominal goal in a web of influences looks naïve at best.

Secondly, the objective that the economy desires to achieve may vary depending upon the stage of growth. It can vary for the same economy from time to time. For EU it is kick-starting growth now, for China is to stabilise it at a high rate, for Japan it is to grow – any growth – even if very low by international standards. For US it was achieving any growth after the meltdown but now slowly crossing over to stabilising inflation. A nominal fixed target does not address these contextual concerns.

Thirdly, economics is mostly about balance and trade-offs between what in general are opposing interests – buyers and sellers, producers and consumers, workers and producers, savers and investors, inflation and growth and so on. One isn’t sure how a nominal deterministic inflation number can work towards an optimal or at least desired equilibrium between savers and investors, between domestic investments and imports at all times even in the medium term.

Lastly, as is explained below, there is excessive and suicidal reliance on the nominal rather than real variables, which is what may be causing the current problem.

No basis

There seems no theoretical basis for the inflation targeting or its levels – not from IMF, not from Basle norms which aims at financial stability or RBI. While nothing can be exact about economics and hence a band is necessary for targets, a 2% tolerance on 4%, is like permitting Usain Bolt to run on his track or the adjacent tracks on either side and the penalties for trespass being imposed 2 Olympics away.

Just orderly movement of forex rates is no policy. When it is clear that it has a significant impact on domestic capacity utilisation, jobs and growth to just aim to only curb the volatility but not be concerned with the values is naïve shirking, much like driving without violating any traffic guidelines or speed limits but towards a wrong destination. By keeping the currency over valued for far too long (over a decade now), we are re-creating conditions of 1991 crisis.

Way forward

Keynes had brought out the true nature of the real and the nominal economy, the rigidities exhibited by the real and how to tweak it by using the nominal to achieve real goals. The current constant 4% inflation (nominal) target can in no way balance the interests between savers and investors, forever. The government should move to a 2% +/- 0.25% real interest rate regime. Whether the inflation is 4% or 9%, such a real interest spread of 2% will be a fair compensation to savers. It will also not curb investment urges if what investors have to pay out is in line what they recover from the market through inflation in prices. This is a sort of inflation proofing both savers and investors.

Such a floating nominal interest (but largely fixed real interest rates) regime will largely ensure that fresh investments and savings do not grind to a halt.

But the existing outstanding stock of savings are in fixed nominal interest regime, which poses problems. It is therefore necessary to move to a floating nominal rate regime and increase its proportion. In the last few years, Bank loans have largely become floating rate with optional repayment and a significant progress has been achieved. It is necessary to increase the proportion of floating rate bank deposits from the savers side as well.

The second thing that is capable of derailing growth and employment in an open economy is the forex rates. An overvalued currency makes imports cheaper, exports far less remunerative which affects domestic employment and growth. A 20-22% overvalued currency as on date is a killer. Government should mandate RBI to walk it along in an orderly manner along the real values. RBI and Government should agree to maintain exchange rates within a band of 97 -103 REER. This REER should be calculated on a base year that is sound when most economic parameters (CAD, fiscal deficit, inflation, growth, etc.) are as close to our desired objective. As it stands now, 2004-05 is one such year. The government should also tailor its inward investment policies accordingly and the degree of capital account convertibility tuned appropriately.

Currently policy rates it appears are decided mostly or solely on inflationary expectations. This can result in fear mongering. In deciding the policy rates, perhaps the actual for the past 2 quarters should be given equal weightage.

By moving to the real from the nominal on both interest and forex accounts, we may have learnt the right lessons from Keynes. Excessive reliance on the nominal on both accounts have made India underperform its potential in the last 4-5 years.

 

 

India is not ready for CPI Based inflation targeting – not yet

It has been close to two years since the Urjit Patel Committee Report set the CPI based inflation ‘Targetting’ as the primary axis of our monetary policy. There are murmurs now from both the Vice Chairman of Niti Aayog and the CEA. In both its key thrusts (i) abandoning the multiple indicator approach for inflation control and (ii) adopting CPI combined instead of WPI as the inflation to target, it is looking like a cricket umpire trying to control the football game in the adjacent ground. With the benefit of hindsight, it looks out of context and tautological in its key arguments and conclusions.

Inflation targeting

“Anchored inflation expectations will … provide the latitude to address other objectives without compromising price stability” (Para II.3). In 18 months RBI has not been able to even ‘anchor’ interest rate expectations – there is so much of debate before each meeting and annoyance after. To anchor inflation expectation by stabilizing inflation to provide a stable interest rate regime to create ideal conditions for investments to generate employment and growth … by the time this comes about it may be Saturday in the Economic Solomon Grundy’s life cycle.

‘High inflation expectations exhibit far greater stickiness than inflation (para 3.2).’ In the past 5-6 years most of inflation has come from agricultural commodities and fuel – segments least under RBI’s control. Our agricultural markets are the most ‘perfect’ markets and given Indians’ mindset of ‘bargain everything’, prices quickly readjust to imbalances. If the Onion prices ruled at Rs 80 one week and slid to Rs 20 the next 2 weeks it is inconceivable that anyone’s expectation will be guided by the Onion prices that prevailed 3 weeks ago. The reverse is also true. Trying to stabilize them through interest rates is a fruitless exercise.

The level of emphasis to be given to inflation control should ideally depend on the national ‘wealth to current income’ ratio. Where it is high and more citizens depend on interest from savings for livelihood, preservation of money’s value is more important. India’s ratio will be dismal comparatively and hence there was a need to balance it with growth and employment objectives. In our context jobs are the best social security.

Constraining Targets

The targets set are a source of worry, for growth itself can cause inflation. For example, in a 2 product, 2 player economy producing 4 coconuts and 2 fish, each fish will retail for 2 coconuts. If the productivity of coconuts increases to 6, the price of fish will become 3. In a monetized economy, wages are terribly sticky downwards and the price of coconuts (derived from the wages which do not move downwards) will remain the same and the price of fish will move up by 50%. There will be the inevitable inflation even if the weights are corrected. This is harmless inflation however. Suppressing this will only result in curbing growth.

A constant inflation target of 6% (+/- 2%) irrespective of whether the growth is 4.5% or 8% seems meaningless.Given India’s rigidities and the way minimum wages are revised whimsically, a 6% target may be far too constraining for a 8% growth target.

In a place like Singapore where trade credits are near totally from banking system, and firms are leveraged 3 or 4 times and work on thin net margins of 2 percent, a ¼ % is a huge dampener and firms might start cutting down on stocks from the next cycle itself. In India with 10-12% gross retail margins a large proportion of which is imputed labour and imputed rent – both far less sensitive to interest rates – and credit largely accessed from non-banking sources, a ¼ % interest rate adjustment to tame or stoke inflation seems irrelevant. Large dosages to achieve a given reduction in overall inflation will hurt a whole host of other sectors disproportionately.

Pitfalls of a statistical approach

The report relies on the New Keynesian Philips Curve equation as the theoretical framework. The 3 factors listed (output gap, cost push, and expectations) in the supply block of equation while relevant is far from decisive or comprehensive. Let’s see an example – how ‘cost push’ can be highly episodic or fickle.

The supply curve is the marginal costs of various firms stacked in increasing order from most efficient to most inefficient and the price is determined purely by the marginal cost of the most inefficient firm required to fulfill a given level of demand. The cost structure of all the other more efficient firms stand irrelevant. Where the most marginal supplier unit (which determines the price) happens to be an overseas firm, prices will be purely determined by import parity. Domestic cost structures do not matter at all: what will matter is the cost structure of source countries. In such a case currency movements play a much larger role.

Again, where the marginal cost difference between the least competitive firm and the next is low or negligible, output gaps may not have an impact on inflation at all.

One does not know how one can form firm action-effect inflation targeting policies on such highly fickle variables alone.

Flawed assumption

The report justifies targeting since ‘persistent inflation worsens income distribution as the poor carry greater proportion of cash’(II.1). This is spurious sympathy. Poor carry cash largely for transaction demand. In rural areas savings till the next season is largely in grains and savings over longer term is in Gold. Surplus cash in the informal sector finds its way largely into small unorganized chit funds and informal credits earning 5-6% per month. It is impossible to conceive that they carry cash over longer time as savings. A cash balance of 2 months when inflation is 12% per annum suffers 2% value dilution. This is just 1% higher than at the targeted inflation levels – hardly relevant which only shows a lack of contextual knowledge.

Inflation in a way represents existence of consumer surplus. In the initial wave, it’s only products with high consumer surplus that will move up in price. There is no reason for RBI to be an arbiter in such a case. It is only in the secondary waves prices of others will move up before it becomes a monetary phenomenon. If those affected in secondary wave are interest rate sensitive then to target inflation with interest rates becomes logical: but only if.

Any regulator will have to keep the aspirations of the people in mind. Ask any job seeker whether he would prefer a job or live with an additional 5-6% inflation. Employment will most certainly be preferable to preservation of value. Growth expands employment opportunities. To be dismissive of these almost mockingly and concentrate on CPI based inflation is to forget the context.

One wishes the Committee had taken advantage of recent advances in Behavioral Economics while formulating its recommendations.

Link to the article published in Businessline: http://www.thehindubusinessline.com/opinion/inflation-targeting-makes-no-sense/article8253638.ece