India - Monetary Policy;Bland & Confusing

Abheek Barua / New Delhi October 27, 2008, 0:03 IST



The RBI’s monetary policy announcement last week did not spell out its likely strategy.

I must confess to being somewhat confused by Friday’s Monetary Policy Statement. Like most others, I was not expecting much in terms of actual policy measures since so much had been done in the past few weeks. I looked forward, however, to a rationale of why the RBI had chosen to act as aggressively as it did, slashing the CRR by two and a half percentage points and dropping the policy “repo” rate by a good percentage point. I also hoped to get clear guidance from the central bank on what its likely strategy is likely to be going forward. I was disappointed.

I thought the section on the stance of the monetary policy (the critical section of this huge document) started rather well. It spoke of the need to focus on financial stability given the extreme turbulence in the global financial system. It described the “knock on” effects of the global crisis on the local financial sector that had exacerbated the liquidity crisis in the middle of September and why the RBI acted swiftly to thwart a credit squeeze. After that I lost the plot.

Here’s why. After discussing the need for financial stability and the urgency to handle the financial crisis (and the risks for domestic growth that go with it), the policy document turned to the usual spiel on the elevated level of inflation and how monetary expansion has to be “modulated” to address this. The statement asserted that M3 growth needs to be brought down to its target growth rate of 17 per cent from its current level of 20.3 per cent and credit growth (including banks’ investments in short-term credit instruments floated by companies) should come down to 20 per cent from its current level of 29 per cent. Prima facie, this suggests that some serious monetary tightening.

Here’s my problem. The need for financial stability and impending slowdown have necessitated a set of monetary measures that are de facto hugely expansionary. The large infusion of liquidity and the cut in the “repo” rate seem to be a clear exhortation to banks to lend more liberally and preferably at lower interest rates. Any hint of tightening at this stage could just create unnecessary confusion.

Second, it is impossible to predict when the global financial crisis will end but it is reasonable to assume that the acute problems in the global markets will persist for a while. It is, by now, clear that the international crisis is impinging seriously on domestic liquidity and could affect credit delivery and affect growth. The run on the rupee is likely to continue and the RBI’s intervention in the markets to thwart this will entail a draft on liquidity that the central bank will find it imperative to offset. The government’s cash calls on the market are likely to be substantial. In such a scenario, the RBI will have to ease monetary policy further unless it wants to spawn another serious liquidity crisis.

Thus, if financial stability was to get top billing (as it should), the monetary targets that the RBI had set out earlier will have to be abandoned or modified. A strict mechanical approach to inflation management will also have to go, at least temporarily. If that is indeed the case, reasserting a commitment to monetary targets that were set against a substantially different macroeconomic background serves no useful purpose and can be misleading.

The RBI’s recent actions seem to make it clear that it has indeed struck a trade-off between the conflicting objectives of monetary policy and is working with a clear strategy. It is willing to keep the liquidity and credit channels well lubricated even if it means a looser grip on the monetary levers. In short, there is a clear monetary stance implicit in the set of measures that it has taken over the past few weeks. Friday’s policy statement should have clearly enunciated this stance and made it explicit. It did not. The financial markets were looking forward to some straight talking on how the central bank is likely to shield us from the financial tsunami that’s rolling in from the West. What it got instead was a rather bland sermon on the multiple goals of monetary policy.

Can a central bank afford to be candid or does its rhetoric have to be couched in Greenspan-esque ambivalence? Can it actually claim to take its eye off the inflation ball when other forces threaten to overwhelm? Recent experience shows that central banks are indeed doing this. Take the case of the Bank of England, which works with an explicit mandate of maintaining consumer price inflation at 2 per cent. It has made it abundantly clear that with the financial crisis threatening to take the British economy into deep recession and rocking the financial system, the cost of trying to bring inflation to its targeted limit (by further monetary tightening) far exceeds its benefits. As the Bank’s governor Mervyn King’s public letter to the Chancellor of the Exchequer put it: “If Bank rate (the principal policy tool) were to bring inflation back to the target within 12 months, the result would be unnecessary volatility in output and employment.” The RBI should have chosen a similar line.

How should one interpret Friday’s monetary policy then? My advice would be: do not get distracted by the conflicting signals from the policy. Governor Subbarao, despite his lack of experience in the hot seat, has been extremely astute and nimble in addressing the financial crisis over the past few weeks. In doing that, he has clearly showed his hand. Monetary policy is unlikely to change course unless the financial crisis abates. The probability of inflation decreasing substantially from current levels has gone up with the growing likelihood of global recession. Analysts might want to parse the credit policy statement endlessly to find signals to the contrary but I am convinced that more rate cuts and liquidity infusion are on their way.

The author is chief economist, HDFC Bank.