Inflation in India has remained stubbornly high. Late in January, RBI raised interest rates again. Some have complained that high interest rates have been choking growth. Others have argued that interest rate policy is ineffective in the current Indian context, where other factors are driving inflation. I argue here that RBI is doing things better than it ever has before. Not only is it being clear in its objectives, but it is also moving toward a consistent policy framework that has often been absent in the past: it seems that the days of ad hoc, and even muddled, monetary policy responses are coming to an end.
The role of the new leadership at RBI, which is manifesting itself in greater decisiveness and in organisational changes, is an obvious factor in shaping one?s optimism about India?s monetary policy. But there also seems to be an accumulation of technical experience and analysis that is helping to guide policymaking. As an example, consider the RBI working paper by Muneesh Kapur and Harendra Behera, published in 2012. This paper builds a small macro model (using quarterly data) to examine the interaction of monetary policy, inflation and growth. The authors consider all the possible factors that come up in media discussions of what has been driving inflation in India: oil prices, other commodity prices, minimum support prices (MSPs), the exchange rate, rainfall, and fiscal deficits.
Typical discussions of inflation in India focus on one or the other factor, and make assertions rather than checking their claims against the data. Even when the data are analysed, the exercise stops at observations of patterns or correlations. In fact, many of the potential culprits in the inflation process are themselves determined jointly with inflation and growth in a complex economic system replete with feedback loops. This is precisely what Kapur and Behera seek to model.
Of course, modelling a complex system means that the conclusions are not simple. But some things are easy to describe in broad terms. It seems that interest rate policy does have the expected impacts on inflation and output, albeit with estimated magnitudes that are relatively small. The model not only supports this conclusion, but it estimates the lags with which effects occur, and the magnitudes of effects in the short run and over longer periods. The model also suggests that higher MSPs feed inflation, but themselves may have been influenced by increases in overall price levels, in a vicious circle. Exchange rate changes also play a role in stoking or soothing inflation (though the model is missing the crucial feedback loop to the exchange rate itself). Fiscal deficits actually do give a temporary boost to growth, but their longer run impact is negative because of crowding out.
The foregoing gives a flavour of what the model tells us. There are many nuances and caveats I have missed, which the authors are careful to include. No doubt the model can and will be improved on. But here I want to stress the positives: this exercise has emerged from RBI, it is public, it can be replicated and improved on by any interested researcher, it is informed by global best practice with respect to empirical methodology and theoretical concepts, it includes robustness checks and sensitivity analyses, and it acknowledges and builds on quite a few previous analyses by Indian researchers on Indian monetary policy and inflation dynamics (as well as by many global researchers for a wide range of economies). These characteristics may seem obvious ones, but in my view they contrast with past approaches in which India was exceptional, so it could not be compared to or learn from other countries, and where both policy and structure were in constant flux, so that searching for empirical regularities was considered to be futile.
Perhaps I am exaggerating the change in perspective on policymaking, but what I have described as ?past approaches? to monetary policy formulation may still fit many other contexts of economic policymaking in India. So, my claims can be tested more broadly. Indeed, one lesson I drew from Kapur and Behera?s model is that the major causes of India?s recent growth slowdown have to be found elsewhere than in the conduct of monetary policy. If there is a comparable model that provides insight into the problem of slowing growth, I have not seen it. Of course, it could be that the problem is simply the political uncertainty and policy paralysis that has gripped India?s national government, and it may be impossible to model that underlying cause, but one can still seek the empirical regularities in investment and saving behaviour, and their impacts on growth.
I should also admit that I do not know if the analysis performed by Kapur and Behera has directly influenced any subsequent decision making at RBI. I do know, however, that the current governor and other key decision-makers would have no difficulty in absorbing and assessing the kind of analysis I have described here. And that is all to the good.
Nirvikar Singh
The author is a professor of Economics, University of California, Santa Cruz
