RBI’s decision not to cut rates in its policy review is, charitably put, puzzling. But before critiquing that decision, let’s identify a big analytical problem in RBI’s argument—a problem that explains the status quo on rates. RBI points to robust growth on a year-on-year basis of indicators such as non-food credit and the WPI, the inflation measure. In a time of rapid changes in the economy, the use of year-on-year indicators is suspect. The year-on-year change of WPI between December 2007 and December 2008 is the sum of the 12 changes that have taken place in between. But what is really important are the values of the most recent months, which show a rather different picture. Point-on-point growth of WPI shows values of -12.5% for October, -23.8% for November and -20.1% for December, all on an annualised basis. Similarly, non-food credit shows point-on-point growth of 7.3% in November and 4.2% in December on an annualised basis. This picture is completely different from the benign story portrayed in RBI’s document. The use of faulty statistical methodology at RBI would have been merely unfortunate had the policy consequences not been serious. That consequence is the decision not to cut rates, justified by references to year-on-year data on WPI and non-food credit. There’s a bigger analytical weakness, in fact. Monetary policy must always respond to forecasts of inflation and forecasts of output. Even if presented correctly, past data—going until December 2008—is not important. What is important is to have a view of inflation through calendar 2009.
A broad array of economists would forecast inflation in India to register values of zero or slightly negative values in 2009. As a consequence, the short-term interest rate (the rate on 90-day treasury bills) of 4.5% that prevails today works out to a real rate of 4% to 6%. This is a highly restrictive monetary policy stance, one that is out of line with the state of the economy. Another analytical googly: RBI has said, in an almost offhand way, that it is targeting CPI, and not WPI. Such a major change in the monetary policy mechanisms, if it has really taken place, cannot be dealt with in such an offhand manner. In well-functioning policy set-ups, the ministry of finance gives the central bank an instruction about which inflation measure to target. A substantial effort of research and communication needs to take place if RBI has switched from focusing on WPI to focusing on CPI. Almost passing remarks on such a subject, as in the credit policy statement, are grossly inadequate.
Changing the game
The credit policy, it seems, has failed to come to grips with the real problem. Monetary policy is not an end in itself. That is, modifying the short-term interest rate for riskless borrowing in the economy is not important per se. The real power of monetary policy lies in its ability to influence the cost of equity and debt capital for myriad individuals and firms all across the economy. If monetary policy can do this, then it is useful and can contribute to alleviating a downturn. If monetary policy cannot do this, then changing the short-term interest rate doesn’t alter the game at all. Of course, the first-order problem is the lack of monetary policy transmission. RBI has done well in cutting rates at the short-end of the yield curve from October 2008 onwards. But these changes have clearly not propagated into a reduced cost of equity and debt capital all across the economy.
Now, theoretically there are two ways of looking at this from the policy level. The ideal way is to start addressing the systemic reason why plentiful raw material—cheap money at the short end—is not translating into cheaper equity and debt capital all across the economy. This kind of approach will worry about questions like why changes in the short rate make no difference to stock prices. The answer: banks are largely walled off from giving loans against shares. It will also take the broad contours of financial reform and apply them to banking, bond markets, derivatives and futures, etc. But assuming Dr Subbarao’s plan of action is more limited in scope, he still must recognise that if RBI is to matter at all in alleviating this downturn, the institution must be a game-changer now, when forecasts of future inflation and aggregate demand are pointing south. These columns had argued for a sharp cut in policy rates precisely for this reason. They had also pointed to the lack of competition among financial firms. What do we have as the effect of monetary policy right now—an irrelevant game where the price at which banks lend to each other on the call money market is modified, and nobody else is affected; where banks’ treasury operations on government securities are earning them profits and nobody else is benefiting from easy money. True, RBI doesn’t have to wait for scheduled policy reviews to cut rates. But what’s the point of scheduled policy reviews in these critical times if the central bank can’t get its analytical and policy approach right?