The politics of the monetary policy debate

The Reserve Bank of India (RBI) has finally succumbed to the increasingly mainstream demand for lowering interest rates. In its mid-quarterly monetary policy review, it has lowered the repo rates by a substantial margin of fifty basis points.

Conventional wisdom would have it that the RBI makes its interest rate decisions on objective considerations based on clearly defined parameters. Even assuming the inevitable discretionary judgement that goes with such decisions, the broadly technocratic nature of such decisions are widely accepted. It is also assumed that these decisions stabilize the economy as a whole. The twin objective is to keep inflation anchored and boost economic growth.

However, a closer analysis of this decision reveals a deeply institutionalized political and social bias. Two observations from the debate that preceded and also followed this decision.

1. In recent months, there has been a growing belief that the RBI holds the key to restoring India's economic growth. In fact, this belief has come to dominate opinion makers across the world. The apparent simplicity of tweaking a single number, the repo rate, to alter the fortunes of the economy has obvious attractions to all parties - academicians, businesses, governments, and media. It provides an easy opportunity for all and sundry to weigh in with their two ounces of wisdom. Unfortunately, it also takes away from focussing on the real issues at hand and holding governments accountable for their role in restoring economic growth. It takes the pressure off from governments in having to deal with more fundamental structural distortions and need for more reforms.

This impression is also reinforced by a cognitive bias, the availability heuristic. The RBI's interest rate decisions are discrete and high-profile events, very frequently deployed (especially in the past few years), and is associated with clear economic growth implications. Rate hikes increase the cost of capital while reductions have the opposite effect. It therefore becomes very easy for everyone to associate a tight monetary policy stance with growth suffocation.

2. The inflation Vs growth trade-off in monetary policy management, in the Indian context, has critical political overtones. Corporate India is directly and immediately hurt by the high interest rates. It therefore becomes natural for them to lobby aggressively to lower interest rates. They argue that the downside risks to economic growth associated with higher rates are much higher than its corresponding inflation risks.

However, monetary loosening, especially when inflationary forces remain unhinged and the economy is running at its potential output frontier, poses significant inflation risks. And inflation, as the episodes of runaway spikes in food prices in recent years indicate, can very adversely affect the poor. They disproportionately bear the costs of inflation compared to the non-poor and corporates.

In simple terms, leave alone its technical merits, a rate cut now reflects a conclusive preference for one political view over another. The balance sheet squares up clearly - high interest rates increases the cost of production for corporate India, while inflation has only marginal immediate impact; inflation hurts the poor directly while the effect of high interest rates is negligible. In terms of the magnitude of short to medium-term effects, lowering of interest rates and a possible rise in inflation will impact the poor more adversely than corporates and non-poor.     

3. Finally, as I have blogged earlier, RBI's recent tight monetary policy stance goes much beyond inflation control. In recent years, the Indian economy has been growing at a rate much higher than its potential GDP growth rate. In the absence of policies and investments that ease supply-side bottlenecks, this potential growth rate has remained stagnant. Therefore, it became necessary for the RBI to cool down the economy, so as to prevent the build up of inflationary pressures. However, popular debates and mainstream discussion on monetary policy have tended to gloss over this and focus on the growth inhibiting role of high interest rates.    

In the final analysis, these prejudices and biases are reflective of the dynamics that skew the priorities in the formulation of public policies and their implementation in India.

Postscript - I missed linking to this post by Daron Acemoglu and Simon Johnson which highlights how monetary policy in the US too appears to have become beholden to the interests of Wall Street. 

More on China's macroeconomic imbalances

Much has been written about China's economic policies that sought to boost exports at the cost of everything else. It is now very clear that it has come with significant costs and serious external and internal macroeconomic imbalances. Externally, Beijing has aggressively intervened in the market to keep the renminbi undervalued. Internally, it has kept interest rates artificially low which in turn has resulted in severe financial repression and suppressed domestic private consumption.

Economix has an interview with Nicholas Lardy who outlines why these two imbalances, external and internal, are closely linked,

The government adopted a low-interest-rate policy at that time. Deposit rates were held down so that the after-inflation return on bank deposits for savers turned negative. That reduced household income below the path it otherwise would have achieved, leading to a slowdown in the rate of growth of household consumption expenditure. Since most households lack adequate health insurance and retirement programs, they also responded to lower deposit rates by saving even more, so as not to be delayed in reaching their savings goals. That put further downward pressure on private consumption expenditure.

China has adopted a low-interest-rate policy as a mechanism to reduce the costs of simultaneously maintaining price stability and an undervalued exchange rate. The central bank intervened massively in the foreign exchange market to moderate the pace of appreciation of the renminbi, China’s currency. And that intervention led to a large, ongoing increase in the domestic money supply, which the central bank had to offset by the sale of central bank bills and requiring banks to increase their reserves deposited at the central bank. The central bank had to pay interest on these bills and reserves, and the low-interest-rate policy made the cost of these operations less than it would have been had interest rates been market determined.

One could add several other consequences of the low interest rate policy. While it has been a major contributor to the promotion of China's investment driven economic growth strategy, it has also generated distortions in resource allocation, the most prominent and of greatest concern being the real estate bubble.

Stripped off all its macroeconomics, China's investment and export based economic growth strategy has been underpinned by massive government inflated bubbles, in multiple sectors. And for much more than a decade now, the country has managed to successfully carry on the strategy. The government kept interest rate and exchange rate suppressed so as to boost investment and exports. Coupled with capital controls, low interest rates, boosted the coffers of the country's public sector banks with cheap capital, which they on-lend to businesses at low rates. Real estate market boomed, which amplified the finances of state entities and local governments which owned all the land. These agencies leveraged the high real estate values to raise resources to finance their massive infrastructure investments. On the external side, the low exchange rate raised export competitiveness, which in turn encouraged massive inflows of foreign direct investment. A sustained period of widespread global economic growth provided all the favorable conditions for China to pursue this export strategy uninterrupted.

There are several dangers associated with this strategy. Lardy himself points to one such transmission channel,

Urban households have piled into property investment in part because of negative real interest rates on bank deposits, and capital controls that prevent most households from investing abroad. The property boom is based on the widespread assumption that property prices will continue to move upward with only brief and shallow price corrections. If this expectation changes, investment demand in residential property could evaporate. Demand for output of steel, cement, copper, aluminum and many other products is driven largely by residential real estate, so if that sector slumps it could usher in a long period of much slower economic growth.

While the rulers in Beijing certainly deserve their share of compliments for the country's spectacular economic growth, it cannot be denied that China has enjoyed more than its fair share of luck and benefited from favorable external circumstances. Now that the consequences of the imbalances, especially the internal ones, are becoming ever more apparent, Beijing ins being forced to re-evaluate its options. Low interest rates are becoming unsustainable for a variety of reasons, making over-reliance on the investment-driven growth strategy unsustainable. Propsects of anemic economic conditions in much of developed world for the foreseeable future puts question marks on the export-led growth approach.

In the circumstances, re-balancing will have to involve nudging the Chinese consumers to play a more central role. This will require rewarding and incentivizing them with higher interest rates and more diversified and remunerative investment alternatives for their savings (read greater financial liberalization). Further, manufacturing wages will have to become more market determined, so that people's purchasing power increases proportionately with the economy's growth. Both these will have to be accompanied by domestic policies that establish a comprehensive social safety net and enabling greater access to affordable urban housing, tertiary education, and so on.

The fiscal and monetary "wiggle-space" - where does India stand?

Free Exchange points to the contrasting macroeconomic positions of developed and emerging economies. While the former has limited fiscal and monetary space to stimulate their economies any more, the later have adequate cushion on both fronts, if the need arises.

The average budget deficit of emerging economies last year was only 2% of GDP, against 8% in the G7 economies. And their public debt ratios were on average only 36% of GDP, compared with 119% of GDP in the rich world.

The Economist article uses a mix of fiscal and monetary policy paramters to arrive at the respective nations flexibility to manoeuvre with expansionary policies. It points to five parameters that determine the monetary policy space - inflation, credit growth, real interest rate, exchange rate movements, and current account balance. It added up the scores on these five parameters to produce an overall measure of monetary manoeuvrability. On the fiscal policy side, it constructs a fiscal-flexibility index, combining government debt and the structural (ie, cyclically adjusted) budget deficit as a percentage of GDP.



It ranked 27 emerging economies according to their monetary manoeuvrability and fiscal flexibility using a "wiggle-room index" constructed using the aforementioned parameters. This index is a reflection of the ability of countries to withstand a global downturn by stimulating their economies. The verdict,

The index suggests that China, Indonesia and Saudi Arabia have the greatest room to support growth. At the other extreme, Egypt, India and Poland have the least room for a stimulus, thanks to excessive government borrowing, large current-account deficits, and uncomfortably high inflation. Brazil is also in the red zone.

At first glance, on most parameters, India stands out as being among the most constrained of emerging economies. On the fiscal side, its combined government fiscal deficit of around 9% of the GDP, means that there is limited space available for any stimulus spending.

However on the monetary side, given the recent declining trend in inflation, the 13 consecutive repo rate increases by the RBI in response to rising inflation gives the central bank adequate monetary space to stimulate the economy. Further, since credit growth has been below par and exchange rate appears to have weathered its brief period of volatility, the monetary side space may not be as constrained as it appears now.

Further, while its total public debt, at about 68% of GDP, may look high by the standards of emerging economies, closer analysis reveals that it may not be as dismal as is being projected. Here are three reasons

1. The overwhelming share of this public debt is owed to domestic creditors. In fact, the total external debt (public and private) is estimated to decline to 17.4 of GDP for 2011, with government share being a mere 4.4% of GDP. As of end-September 2011, of the total external debt of $326.6 bn, with government and non-government shares in the total external debt being 24.3% and 75.7% respectively. Short-term debt accounted for 21.9% of the country's total external debt, while 78.1% was long-term. Adjusted for this, the real effective debt burden, in relation to a sovereign debt default risk, shrinks considerably. The only area of slight concern should be the 27.4% CAGR in external commercial borrowings between end-March 2006 and end-March 2011.



2. At 122% of GDP, its overall debt is the second lowest among all the major economies. Only Russia has a lower overall debt-to-GDP ratio.

3. Though its government may be profligate, the other major engines of economic growth - households, non-financial corporates, and financial institutions - have the healthiest balance sheets among all major economies, including China.





This means that all the non-government drivers of economic growth stand on very strong platforms and have enough "wiggle-room" to manoeuvre. All that is now required is for the government to get governance and policies right. Will that happen?

The focus should shift from Mumbai to New Delhi

The sources of India's most recent bout of inflation, as pointed out in a series of excellent recent speeches and papers by RBI officials (see also Amol Agarwal here), may be rooted in structural factors like demand shocks (increased protein consumption) and supply constraints. The continued fiscal accommodation, especially by way of the expansion of the mandate of policies like NREGS, may have contributed towards amplifying the upward pressures.

This means that monetary policy may have limited traction with restraining inflationary pressures, beyond cooling the economy and restraining growth in aggregate demand. Any further changes in monetary policy can only have marginal impacts, especially since the markets have already priced in the RBI's firm commitment to rein in inflation by lowering aggregate demand and thereby slowing down the economy. Blaming the RBI for taking only baby steps or being too predictable with its interest rate increases or even giving up its shock value (the recent announcement that it may not hike rates in December) looks unconvincing.

Translated into English, all this effectively means that the focus of attention on inflation fighting has to shift from RBI to the Government. It means that governments, both states and center, will have to initiate steps to ease supply-side constraints - infrastructure bottlenecks and agriculture production capacity. An aggressive program of investments in these areas is immediately required. Fiscally constrained governments need private sector assistance in many of these areas if there is to be any meaningful impact to ease supply constraints. The very nature and dynamics of their interventions also means that the expectations for immediate outcomes that we associate with RBI's monetary policy actions should be shelved.

It is interesting that during the Great Recession and the economic slowdown that followed the sub-prime crisis, governments across the world have been largely missing in action. Almost expecting this, public debates have been focussed on getting monetary authorities to pull economies out of their current mess. In the developed economies, central banks have indulged in monetary accommodation through unprecedented quantitative easing policies.

In India, the focus on its central bank has been for a different reason. Unlike the developed economies, the problem here is an overheating economy which has unleashed inflationary pressures. Accordingly, attention has been on the RBI to use monetary policy to deliver the magic bullets to lower inflation and boost growth. But, as aforementioned, this strategy has serious limitations and will not yield results. RBI can at best buy time by cooling the economy and buying time for the government to get its act in order. Only governments can fulfill the growth creation and sustaining role effectively.

The only issue at debate is whether the RBI should pause or not. The fundamental objective of the 13 consecutive rate hikes has been to rein in an over-heating economy. This growth restricting objective has to be weighed against the more important medium to long term goal of getting the economy to quickly expand its potential output and productive capacity. This requires massive investments in infrastructure and food production, both by the governments and the private sector.

Has the interest rate crossed the threshold where it has started adversely affecting these investments? This should be the critical question guiding RBI's monetary policy decisions in the months ahead. As for inflation, it is time for New Delhi to assume centerstage and take the "inflation bull" by its horns.

The savings rate de-regulation

The decision by the RBI to deregulate bank savings rate in its second quarter monetary policy review is one of the most progressive and efficiency increasing reforms in recent years. All banks are currently mandated to pay an interest of only 4% on savings account deposits.

In one stroke it eliminates one of the last remaining glaring incentive distortions in India's banking sector. With 26% of the total bank deposits (as on June 2011) being in the current and savings bank accounts, banks hitherto benefited hugely from an artificially lower cost of funds.

It is expected to increase depositors’ interest income by around Rs 9000 Cr. The Businessline reports that assuming the savings bank deposit rates of banks rise by 1 percentage point, profits before provisions and taxes will be lower by 9.3 per cent (based on FY-11 profits) if they do not pass on the deposit rate hikes to borrowers.



This decision increases competition, lowers entry barriers, encourages savings, and contributes to strengthening the financial markets and increasing the effectiveness of the monetary policy transmission channels. In simple terms, it is one of the rare policy decisions which aligns incentives of all stakeholders and increases overall efficiency of the system. Here is a summary of its benefits.

1. It will increase competition among banks and thereby increase all round efficiency in the sector. Banks will be forced into raising deposit rates so as to attract depositers and also allocating their lendings into the most profitable avenues.

2. It lowers entry barriers by working to the advantage of smaller banks and newer entrants. They have hitherto suffered from a system where location of branches conferred an unfair first-mover advantage. Now with the freedom to price their depsoit rates, these banks can hope to attract accounts by signalling with more competitive rates. This was evident in the immediate aftermath of the decision, with Yes Bank announcing hiking its deposit rates by 200 basis points.

3. It will force banks into diversifying into other transaction and advisory services which will in turn enhance the breadth of India's financial system. This will be felt with much greater force by the public sector banks who have a higher exposure to low cost savings bank deposits. Hitherto, the ceiling on deposit rates had provided banks with a large easy source of money and comfortable assured profits from it (SBI alone loses Rs 1500 Cr for every 50 basis points increase in deposit rates). To this extent, the incentives were not aligned towards getting banks to search for alternative sources of revenues.

4. On the consumers side, given the dominant role of banks in household savings, especially of savings bank accounts in case of the poorer people, this deregulation will enable them to get higher returns on their deposits. This will in turn boost household savings and also encourage people in rural areas to utilize bank accounts to channel and save their incomes. Banks too are certain to come up with more differentiated savings products.

5. It increases the effectiveness of monetary policy transmission mechanisms. As deposit and lending rates are arrived through a competitive process, any changes in the repo rates will, in normal times, is more likely to be transmitted quickly into the financial system and the economy.

A graphical summary of the state of Indian Economy

Inflation has remained elevated at 8-10% range for more than 18 months since March 2010. Though the RBI and government have predicted the subsidence of headline inflation for many months now, it remains persistent at these high rates. The RBI's second quarter monetary policy review has projected baseline inflation to be 7% by end-March 2012.



Since February 2010, the RBI has increased rates 13 successive times, the largest such sequence of increases in its history. The repo and reverse repo rates have risen by 375 and 425 basis points respectively during this time.



Adding to the pressure is the steep recent depreciation in the value of rupee. While beneficial to exporters, it has the potential to add to inflationary pressures by making imports, espcially of oil, costlier.



In a reflection of the tightening monetary conditions, anchored inflation expectations, and increased government borrowings (government recently announced an increase in its 2011-12 fiscal borrowing by an additional Rs 52,872 Cr, taking it to a record Rs 4.7 trillion), long-term interest rates have been climbing. Into this milieu the announcement by the government The yields on 10 year government bonds have increased by more than 80 basis points since the beginning of the year.



As a measure of the growing global financial market instability, India VIX, the barometer of equity market volatility, has not only risen but has shown increased fluctuations over the past three months.

The futility of monetary expansion

Given the strong opposition to any further expansion of its balance sheet, the US Fed has not gone ahead with a third round of quantitative easing but settled for the next best option of recalibrating its existing portfolio towards the longer end of the tenor spectrum.

The Fed's FOMC cited "significant downside risks" and announced that over the next nine months, it would sell $400 bn worth securities (treasuries and mortgage backed securities) with maturities below 3 years and purchase those with maturities longer than 6 years. With this, it hopes to twist the yield curve on longer term securities downwards without printing any more money and thereby further expanding its balance sheet.





While there is little doubt that it will have some impact in flattening the yield curve and lowering long-term rates, it is more or less certain that its impact is likely to be marginal. In fact, as witnessed by the steady flattening of the yield curve in the build up to the announcement, the markets may already have factored in its impact.

As an FT article suggested, though the lower long term rates will benefit home mortgage holders, their ability to take advantage of it remains questionable. It is estimated that about a quarter of borrowers have a mortgage worth more than their home and a half do not have the 20% of home equity needed to refinance at a lower rate. This effectively means that the two worst affected categories of mortgage holders will not be able to benefit from the flattening of the yield curve.

The lower long-term yields will also affect the profitability of banks, which traditionally borrow short-term and lend long. The flatter yield curves will dent their arbitrage margins. This will act as a further disincentive for them to lend in an uncertain economic environment.

Small businesses, the traditional engines of economic growth and job creation, especially in the aftermath of recessions, are badly credit constrained. Risk averse banks and financial institutions have been generally loath to lend to small businesses. As the plight of mortgage holders mentioned earlier shows, the battered household balance sheets have some distance to go before consumption can recover.

Most importantly, like the earlier quantitative easing programs, "operation twist" too will come up against the biggest problem facing monetary authorities and governments today - how to translate the dramatic expansion in monetary base and the resultant ultra-low long-term interest rates into increased credit ioff-take. In other words, monetary policies have not been able to make much headway with getting banks to lend, consumers to borrow, and businesses to invest. Except for a handful of the largest firms and financial institutions, credit remains squeezed.

This brings us to the fundamental issue which Paul Krugman and others have been higlighting, about the difficulty of squeezing much out of monetary policy when the economy is stuck in a liquidity trap and where aggregate demand is also in a deep slump. In a liquidity trap, since interest rates are touching the zero-bound (and therefore people do not have to sacrifice interest earnings to obtain liquidity), people are hoarding money not because of its liquidity value, but merely as a store of value. Worse still, since interest rates are close to zero, money and short-term treasuries become interchangeable and mere stores of value. This in turn means that conventional monetary policy actions that involve open market operations by swapping money for treasuries or expanding the money supply become ineffectual.

The graphic below highlights the near complete lack of responsiveness of monetary aggregates to the massive expansion in monetary base. Though the monetary base has exploded, the M2 money supply and its velocity have hardly budged, just as inflation has remained anchored to the bottom.



Clearly, as the graphic below shows, this massive infusion of money has found its way into the safety of bank's reserves.



It is amply clear that the present economic problems cannot be solved just by increasing the supply of money. Nineties Japan and Depression era US provides ample evidence of the futility of such expansion. In the circumstances, the solution lies in boosting aggregate demand. Monetary policy can only work at the margins in preventing the situation from getting worse.

"Twisting" on debt maturities as QE3?

The latest dimension to the US Federal Reserve's attempts to lower long-term interest rates through its quantitative easing (QE) program is "Operation Twist". It involves selling short-dated Treasuries (1-3 years) and buying longer-term securities (mostly 7-10 years) in an attempt to push down longer-term yields. These yields affect corporate borrowing and mortgage rates far more than short-term rates.

Hitherto, in the two rounds of QE (QE1 in 2009 was for $750bn, measured in 10-year Treasury equivalents, and QE2 in 2010 was for $412bn), lowering of long-term rates was sought to be achieved through massive purchases of long-term securities. This has involved a huge expansion of the Fed's balance sheet, though the resultant increased monetary base has been mostly confined to banks' reserves. This expansion of monetary base has generated criticism about stoking inflationary fears, weakening the dollar, and spawning other systemic distortions. It has also come in the way of another round of QE.

The new strategy avoids expanding the Fed's balance sheet and seeks to lower long-term rates by swapping short-term debt for longer-term ones. This would not involve any additional balance sheet expansion and would only cause maturity transformation of existing debt portfolio towards the longer-term. In simple terms, it would be merely re-balancing the Fed's portfolio.

It is estimated that by merely "recycling maturing bonds into longer-dated ones", $110bn would be added, and by "actively selling its portfolio of 1-3-year bonds and buying as much long paper as permitted", the Fed could achieve another $390bn. The former involving about $20 bn a month may not enthuse the markets as much as the later which could involve more than $65 bn a month. The Fed at present owns $632bn in Treasuries with a maturity of less than four years. See this Goldman estimate of Fed's possible Operation Twist strategy.



Twisting of the yield curve is not without precedents, though its impact has not been encouraging. It was first used, unsuccessfully, by the US in 1961 and then by Japan, again unsuccessfully, in the nineties. It carries with it certain clear risks. As the FT writes, it "could disrupt trading flows in the bond market, while reducing earnings for banks that borrow cheaply and invest in long-term Treasury debt". It would adversely affect the returns of institutions like insurance companies and pension funds that have large exposure to long-term debt instruments and also the net-interest margins of banks (who invest in long-term bonds).

Finally, it also increases the long-term interest rate risk in the Fed's portfolio, which could, at certain point, constrain the Fed's policy making freedom. Fed would then effectively become a player in the bond markets. And there also exists the probability of making considerable losses when the Fed exits from its current accommodatary stance. It is also being argued that speculation of Operation Twist has already been priced into long-term yields and not much will be achieved with the actual operations.

Update 1 (22/9/2011)

The Fed announces that it would invest $400 billion in long-term Treasury securities over the next nine months, using money raised by selling its holdings of short-term federal debt, in an attempt to drive down interest rates on mortgage loans, corporate bonds and other forms of credit. With this, the Fed hopes to drive down rates not by expanding its portfolio, as it has done twice in recent years, but by shifting its money into riskier long-term investments.

The Fed has amassed more than $1.6 trillion of federal debt. It said that by June 2012 it would sell $400 billion in securities with remaining maturities of less than three years and buy roughly the same amount in securities with maturities longer than six years. It said the result would shift the average maturity of its holdings to 100 months, or more than eight years, from the current average of 75 months, or just over six years.

Lower interest rates so far had not produced the full measure of predicted benefits because lending standards remained unusually strict. Most outstanding mortgages still carry interest rates above 5 percent, despite the availability of lower rates, because it remains difficult to refinance. Tough lending standards are likely to limit the benefits from lowering interest rates. Loans already are cheap, but they are also hard to get.

Negative interest rates in Switzerland

Amidst all the turmoil in Europe and the global financial markets, a less reported but remarkable event happened when the Swiss interest rates, including medium-term rates, in the LIBOR market plunged into negative territory. In other words, instead of being paid by their borrowers, lenders would now have to pay for the privilege of getting borrowers to accept their money!



As the Eurozone economies plunged into crisis, Swiss Franc emerged as a possible safe haven. The resultant capital inflows boosted the Franc by over 20% against the Euro, hurting Swiss exports and economic growth. In fact, as Gillian Tett writes, the Goldman Sachs has described it as "the most overvalued currency" in recent history, 71% stronger than fundamentals justified.



In response, early this month, the Swiss National Bank (SNB) acted aggressively to lower interest rates to virtually zero (from 0.25%), inject unsterilized cash, build up sight deposits (cash withdrawable on demand from the central bank) with the SNB, and repurchase outstanding SNB bills and use the proceeds to buy Euros in the forex market. The SNB press release said,

"Effective immediately, the SNB is aiming for a three-month Libor as close to zero as possible, narrowing the target range for the three-month Libor from 0.00-0.75% to 0.00- 0.25%. At the same time, it will very significantly increase the supply of liquidity to the Swiss franc money market over the next few days. It intends to expand banks' sight deposits at the SNB from currently around CHF 30 billion to CHF 80 billion. Consequently, with immediate effect, the SNB will no longer renew repos and SNB Bills that fall due and will repurchase outstanding SNB Bills, until the desired level of sight deposits has been reached."

The results of this aggressive response has been spectacularly successful, with interest rates on Swiss two and three-year government bonds falling into negative territory and spreads with German bund widening on the negative side. The Swiss ten year bonds have fallen off precipitiously in the last two months. The futures markets are currently predicting negative rates until 2013 and minus 8 basis points next summer.











This effectively means that "if you want to lend Swiss francs or make a deposit in the next year, you must pay for that privilege", an anomaly that has led to Gillian Tett of FT to describe it as "Alice in Wonderland" economics! Alternatively, anyone holding two-year or three-year Swiss bonds is now demanding that the price exceeds the coupon-included return in order to be tempted to sell.



Apparently, this is not the first instance of negative interest rates. In the 1970s the SNB imposed negative interest rates on foreign accounts to deter inflows; and in 2008 some short-term Swiss market rates briefly turned negative. That also happened in Japan in the late 1990s and recently some dollar short-term rates have touched negative territory. However, in all these cases, the negative rates covered only ultra-short rates, whereas the present Swiss situation is for medium-term rates covering the next two years. In simple terms, borrowers could take out a two-year loan with the assurance that they would need to be paid by the lenders for the next two years.



However, given the depth of the financial crisis, as FT Aplphaville says, even this situation is fraught with dangers. Technically, the build up of sight deposits (which would be used as reserves by banks) should "cause Swiss rates to fall sharply since the more reserves banks hold, the less they require to borrow from each other and the lower the rate falls". FT Alphaville writes about the distortionary possibilities,

"Since the SNB pays zero on its sight deposits, there is a very real risk banks might be encouraged to hoard cash on deposit rather than to lend it out for a negative rate. This would be the exact opposite of expanding the money supply. It might even be contractionary.



Now, the SNB is probably hoping that the extreme unattractiveness of having to pay an additional rate to hold Swiss francs will be enough to encourage holders of the currency (especially those abroad) to sell the franc and move elsewhere. This, theoretically, should flood the market with Swiss francs, lowering exchange rates and easing liquidity. But there is still the danger that the move could drive Swiss francs straight into the coffers of Swiss-based banks, who would then be unwilling to lend them out at a negative rate.



In that circumstance, a deflationary spiral motivated by 'capital preservation' could begin. Once that starts, no matter how much 'QE' money is printed, it becomes completely ineffective at boosting the money supply. In fact, if anything, it arguably becomes a deflationary force because the money is being pumped directly into a liquidity trap, in which capital preservation (rather than yield) is the chief priority of banks and depositors. Which, by the way, happens to be exactly what happened during the Great Depression."

This has echoes of the Great Depression (see this Ben Bernanke paper), when "the market for unsecured lending died a death because counterparties no longer trusted each other",

"Everyone turned towards a collaterised lending regime, one in which only the very best collateral (Treasuries and gold) would do. This had the effect of causing a run towards Treasury securities. No matter how much money was printed by the Fed to ease liquidity concerns it only intensified the obsession with capital preservation. Largely by eliminating the number of Treasury securities in the market. Since, there was no one the banks could lend money to in the wider market due to credit concerns, Treasuries became a bit of a Giffen good. The money had to be parked somewhere... With capital preservation becoming the top priority for banks, institutions were willing to pay more than the face value of Treasury securities, because investing elsewhere would come with too great a risk of default."

In the uncertain environment, as the prices of Treasuries went up (and the yields fell down), banks purchased more of the same. The same story is being repeated today with Swiss Government Bonds, pushing yields into negative territory.



As an update, it does now appear that the SNB's aggressive actions have not been as successful as initially thought in curbing the Franc's rise.

China's Local Government Debts

One of the most intriguing questions for Indians marvelling at China's spectacular economic growth is about how its government manages to finance a never-ending shelf of mega infrastructure projects entailing extraordinary investments. For all its governance failures, corruption, resistance to reforms and recent political paralysis, the fundamental problem for a chronically infrastructure deficient India remains paucity of resources to finance its massive infrastructure requirements.

The contrast with a flush-with-funds China is stark. However, as the Times points out in an excellent article chronicling the challenges facing China's increasingly infrastructure investment dominated economic growth push, things may not be as rosy as it appears across our northern borders.

As the Great Recession took hold, the Chinese government stepped in with a mssive $580 bn stimulus package. Local governments across China borrowed heavily from state-owned banks and pumped money into infrastructure. Infrastructure replaced exports as the engine of economic growth.

The Times reports that spending on so-called fixed-asset investment (infrastructure and real estate projects) is now equal to nearly 70% of the nation’s GDP, a sign of dangerous over-dependence on infrastructure spending. It is a ratio unheard of in modern times for any nation, with the ratio being just 35% for Japan during its 1980s building boom and 20% for US for decades now.



Now this model is becoming unsustainable as local government debts, cleverly hidden from the local government balance sheet through accounting tricks, mount and repayment strains start appearing. The National Audit Office recently released figures showing that the local governments had amassed 10.7 trillion yuan ($1.65 trillion) in debt as of the end of December, amounting to 26.9% of GDP in 2010. Of this debt, local governments are explicitly responsible for repaying 62.6%, have guaranteed 21.8%, and are required to partially repay 15.6%. Worryingly, the report writes that nearly half the debt was accumulated in just two years by way of the loan-powered fiscal stimulus of 2009-10. This debt, mainly owed to state-run banks, poses serious risks for the Chinese financial system.

Most local governments borrow through special investment corporations set up by them and their debt shows up nowhere on its official balance sheet. Such local government financing vehicles (LGFV) were set up to get around rules forbidding them from borrowing directly from banks and raising funds through municipal bonds and also conceal the true extent of local government debts. These LGFVs were set up to finance light rail projects, bridges etc. It is estimated that there are more than 10,000 of these local government financing entities in China.

In fact, the audit office said 46.4% of the debt is held by such intermediary vehicles. Another recent report from the People's Bank of China had said that local government financing vehicles had taken out loans worth up to 30% of total outstanding bank loans or 14 trillion yuan. The collateral for many loans is local land valued at lofty prices that could collapse if China’s real estate bubble burst.

An earlier estimate by the Northwestern University Prof. Victor Shih found that the total local government financing platform debt was around 11.4 trillion yuan ($1.75 trillion) at the end of 2009. His latest estimate of total local governmental debt ranges between 15.4 trillion yuan and 20.1 trillion yuan, or 40% to 50% of China's 2010 GDP. He also estimates that LGFV interest payments are at least 1 trillion yuan a year, and realistically more than 2 trillion yuan.

Another report by Moody's says that the audit office's data fails to account for about 3.5 trillion yuan, or about $540 billion, of loans to local governments. It also estimates that the Chinese banking system's nonperforming loans could reach between 8% and 12% of total loans. This is in stark contrast to the official ratio of non-performing loans of 1.14% at the end of 2010.‬

The biggest concern is a possible rise in inflation, which would force the central bank into raising interest rates. In fact, yesterday the People's Bank raised interest rates for the third time this year in order to cool the sizzling pace of economic growth, estimated to touch 11.9% in the seond quarter. Inflation is up 4.4% for June, the highest rate in more than two years and above the 3% target set by central bank.

In fact, the threat of the whole pack of cards collapsing when faced with higher interest rates is also behind the reluctance of authorities to rein in the bubble. As Prof Shih argues, the only way to cool down the continuously inflating debt bubble and credit flows is by engineering a credit crunch. Unfortunately, this would entail raising interest rates, with all its possible adverse consequences.

There have been rumors that the government is considering write-off about 2-3 trillion ($300-470 bn) in debts owed by local governments to the country's China's top banks. Though this would force losses on banks, local and central governments, it should reduce the risks that cloud the Chinese economy. Fortunately, a banking crisis would not have the sort direct impact on consumers as witnessed in the US since the Chinese citizens save heavily and have limited exposure to mortgages and other financial investments.

The debt build-up also amplified the already frothy real estate market, which was pushed up further by the stimulus spending in 2010 and 2011. A large share of this spending was routed into real-estate related infrastructure. Chinese state-owned banks, on government orders, lent about $3 trillion mostly to giant state-owned enterprises and local governments to fight the effects of the downturn. Though intended at infrastructure, a substantial share of these loans wound up financing real-estate purchases by government agencies.

Further, in the absence of financial alternatives to beat inflation, Chinese savers piled into real estate and drove residential property prices up by half to about 9% of GDP between 2006 and 2010. In that period, real-estate prices in major cities in China roughly doubled.

The continuing paucity of investment avenues coupled with exceptionally high savings rates and the reliance of local governments on land sales for revenue means that property prices could go higher before the bubble bursts. The Standard Chartered estimates that about 50% of China's GDP is linked to the fate of its real-estate market (it affects construction, steel, concrete, power and appliance industries), making a potential bust extremely damaging. A banking crisis would be inevitable.

See also this Times Room for Debate on China's local government debt.

Automatic fiscal stabilizers and counter-cyclical fiscal policy

I have blogged extensively about the utility of fiscal policy in combating aggregate demand slumps, especially when the economy is facing the zero-bound in nominal interest rates.

However, unlike the more rules-based monetary policy, fiscal policy is subjective and deeply political. The classic fiscal policy alternatives like direct government spending on infrastructure face the problem of implementation lags. In contrast, automatic stabilizers kick-in immediately, being targeted on those most likely to spend any money provided to them. It no surprise that automatic stabilizers - unemployment insurance, food stamps etc - have among the highest fiscal multipliers.

The WSJ points to the apparent success of Sweden in managing its recovery from the Great Recession and attributes it to successful expansionary policies by both the government and the Riksbank. The Swedish economy grew 5.5% in 2010 and unemployment rate has fallen from its peak of 9% to 7%. Instead of high-profile direct spending and tax cuts, the Swedish government responded swiftly with automatic stabilizers to provide income, health care and other services to people who are unemployed. The Riksbank, initially lowered rates aggressively to zero, even taking it to minus 0.25% (savers had to pay 0.25% for the privilege of keeping deposits). Its quantitative easing program was more expansionary than even the Fed - the Riksbank's balance sheet was more than 25% of GDP in the summer of 2009, compared to 15% for the Fed.

Further, unlike many other developed economies, Sweden entered the recession in excellent fiscal health - its budget had a 3.6% of GDP surplus in 2007, to 3% deficit in the US. This gave the government enough cushion to indulge in extended fiscal expansion when recession struck. This was a result of a strong commitment, borne out of the bitter experience of its banking and economic crisis in early 1990s, to maintain a counter-cyclical fiscal policy.

Clice Crook points to the example of the US, where though the Obama administration came up with a large fiscal stimulus in 2009, mostly with tax cuts and direct spending, its impact was offset by the severe fiscal tightening by the local governments. He also writes about the relative lack of influence of fiscal stabilizers in the US,

"Two factors weaken automatic stabilizers in the US. First, the government is small, so economic fluctuations, other things being equal, move fiscal quantities less. Second, states are subject to balanced-budget rules. Much of the US government has to follow a pro-cyclical fiscal policy – cutting spending and raising taxes – during a recession."

The acrimonious debates surrounding fiscal expansion in the US underlines the need for a much greater role for automatic fiscal stabilizers. However, it is also important that these automatic stabilizers have automatic sunset clauses that ensure exit from fiscal expansion when the economy recovers. Mark Thoma makes an excellent case for greater use of automatic fiscal stabilizers during recessions.

In this context, Jeffrey Frankel, Carlos A. Vegh, and Guillermo Vuletin (pdf here) examined long-term fiscal policy in 94 countries (73 developing and 21 developed countries) over the 1960-2009 period and found that "the cyclicality of a country’s fiscal policy – a sign of its riskiness – is inversely correlated with the quality of the country’s institutions".

They examined the correlation between government spending and GDP for these countries over two periods, 1960-1999 and 1999-2009, and found a significant increase in countries with negative correlation (or counter-cyclical spending) over the two periods. In fact, among developing countries, those following counter-cyclical policies increased four-fold to 35% over the two periods. The graphic below indicates the correlation between spending and GDP for these countries in the 2000-09 period, with yellow and black bars representing developing and developed countries respectively.



The increase in counter-cyclicality in the conduct of fiscal policy by developing countries is evidence of greater maturity by policy makers and policy institutionalization in these countries. This maturity is corroborated by other indicators like reduced debt-to-GDP ratios in many developing countries. The authors "find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment". They highlight the success of Chile with counter-cyclical fiscal policy and attributes it to institutional strengthening reforms since 1980s.

The Great Indian Inflation Challenge

The great Indian inflation debate shows no signs of abating and if the prevailing trends are any indication, it may continue well into the foreseeable future. The RBI recently enacted its 13th continuous repo rate increase in an attempt to bring inflationary pressures under control. But monetary policy may be on its last legs as the negative impact of high interest rates on economic growth already appears to have become predominant.

In the circumstances, it is not surprising that inflation has become a political football. Opposition parties, civil society organizations, and opinion makers in the media cry hoarse at the government's inability to bring down food prices. They blame everything from bad policies to corruption to inefficient bureaucracy to hoarding for the persistence of inflation. Why is the inflation monster becoming so intractable?

Econ 101 teaches us that economies are at their most efficient when they grow at their production possibility frontier, which is a function of the basic resources - manpower, capital, and infrastructure - available in the economy. Any economic growth is under-pinned by these available resources. As economies expand at their natural pace, it accumulates these resources, and a positive virtuous spiral of growth is generated - growth brings in tax revenues, which are funneled into capital investments, which in turn creates the platform for further growth.

However, when the economy experience a sudden growth spurt, wherein the trend rate of growth is suddenly lifted up, the available resources often get depleted quickly and its growth may fail to keep pace with the needs of economic expansion. In simple terms, the economy grows much faster than the supply of resources required to sustain the expansion. More factory capacity is built up than electricity supply can support; manufacturing production exceeds the ability of transportation facilities to move them by road, water and air; cities grow much faster than local governments can provide civic infrastructure facilities and so on. The economy is "over-heating".

Amplifying all this is the impact of growing incomes generated by the booming economy, which changes people's living habits and expenditure patterns. If coincidentally the government is indulging in some direct fiscal spending to boost incomes across the board, then the demand pressures burst open. In such circumstances, where aggregate demand is on the up and the supply infrastructure and other basic resources not keeping pace with the requirements, inflationary pressures are inevitable.

India is experiencing something similar to that described above. A decades long trend annual growth rate of around 5% suddenly gave way to near double-digit rates since the turn of the century. Once the initial slack and spurt of government investments had run its course, the supply constraints started showing up. The supply of capital resources stagnated and failed to keep pace with galloping demand.

Targets in critical infrastructure areas like provision of civic utilities, roads, power generation, port capacity addition, agriculture storage etc were repeatedly missed. A severe shortage of skilled factory and construction manpower and qualified engineering personnel has very badly affected businesses. The high interest rates are only exacerbating this trend by creating constraints on the supply of capital.

The well-intentioned NREGS has had the direct impact of giving thousands of crores of additional cash in the hands of rural poor, besides boosting labour wages across the board. The income effect created by all this has increased disposable incomes and boosted aggregate demand across the economy. The supply-side has badly lagged behind this huge spurt in demand. Inflation was almost inevitable and will persist till these conditions change.

It is clear that while the demand side is robust, the supply side appears constrained. The rise in inflation is therefore more due to cost push factors than demand pull ones. The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The major domestic supply side bottle necks that have been driving prices up include stagnating agricultural production and over-stretched infrastructure, especially power and transport logistics.

Assuming that the lions share of infrastructure investments should have come from governments, it would be reasonable to expect government investments to have increased atleast as spectacularly as the recent spike in GDP growth rates. However, even as gross fixed capital formation as a share of GDP has increased impressively since about 2003, government consumption as a share of GDP has remained stagnant. This is despite the considerable increases in government consumption by way of petroleum and other subsidies in recent years. It can be safely presumed that government capital investments, especially in infrastructure, lags badly and remains woefully inadequate.



On a historic perspective, India's economy has, atleast since about 2003, reached a new and higher growth phase. However, this (involving the near doubling of the average growth rates from about 5% annually to about 10%) has not been accompanied by any commensurate increase in government consumption (the spurt in 2008 can be attributed to the different kinds of stimulus spending).



The choices facing the Indian economy are stark. If it has to rein in inflation in the foreseeable future, capital investments in physical infrastructure and human resources will have to increase exponentially. Or else, faced with chronic supply constraints, inflation will persist, and ultimately growth itself will get compressed. Either are not easily resolved and will take considerable time.

The most plausible scenario appears to be a slip back into an intermediate trend growth trajectory, where moderation of growth stabilizes inflationary pressures. Hopefully, this time, the government gets its act together and channels massive investments into basic physical and human infrastructure, so as to set the stage for recovering back into the current high trend growth stage quickly.

PS: Once the over-heating economy line of reasoning is accepted, the central bank faces no trade-off between inflation targeting and economic growth. The objective then is to do monetary tightening so as to cool down economic growth to a level where the supply-side growth is in sync with the aggregate demand growth. The danger of course is that no-one knows how much tightening or cooling is optimal!

Update 1 (4/7/2011)

Evidence of overheating economy comes from this graphical survey by The Economist. Using inflation, current GDP and employment growth rates over the average of the past decade, credit growth rate, and current account deficits, it finds that India is among those handful of emerging economies which are clearly overheating.

The competitiveness mismatch in Europe

Paul Mason (via Paul Krugman) has an excellent graphic that captures one of the fundamental problem facing many peripheral economies of Europe - lack of competitiveness.



He writes,

"There is a huge competitiveness mismatch and a resulting huge trade mismatch. The south became an export market for north-European manufactured goods, and a credit market for the north-European banks - which may have been technically constrained to be dour and presbyterian by domestic law but nevertheless piled into the Irish and Spanish property bonanza with gusto. Everybody benefited from the credit bubble; but Germany has above all benefited from the Eurozone's structural imbalance."

And The Economist is spot-on in its analysis of Portugal's problems,

"Portugal now joins Greece and Ireland in the euro zone’s intensive-care ward. Its public debts are nowhere near as monumental as Greece’s; its banks not as reckless as Ireland’s. It has succumbed because of a humdrum failure to rein in wage increases and to modernise a bureaucracy schooled in tallying the quiet remains of the first global empire, as well as an inability to coax upstanding family companies, which for centuries have crafted textiles, ceramics and shoes, into competing with the Chinese."

Fiscal austerity is not going to solve the competitiveness deficit, as Greece is finding out, through its three-year €110 billion ($155 billion) EU/IMF combined emergency bailout of May 2010,

"The real source of gloom is the shorter-term impact of austerity. A year ago the plan forecast that GDP would shrink by 4% in 2010 and 2.5% in 2011. Instead it fell by 4.5% last year and IOBE predicts it will decline by 3.2% in 2011. The unemployment rate has risen from 9% in mid-2009 to 14.2% in the last quarter of 2010, and is expected to average 15.5% this year... progress in cutting the deficit in 2010 was slower than envisaged. Provisional estimates put it at an oppressively high 10.6% of GDP rather than the original target of 8.1%. Debt is now close to 145% of GDP... Ten-year government-bond yields have climbed to almost 13%. The credit-rating agencies have recently downgraded Greek sovereign debt still further, from junk to junkier."

The solution, as Paul Krugman writes, is a combination of German inflation and Spanish deflation,

"During the eurobubble years, there were huge capital flows to peripheral economies, leading to a sharp rise in their costs relative to Germany. Now the bubble has burst, and one way or another those relative costs need to be brought back in line. But should that take place via German inflation or Spanish deflation? From a pan-European view, the answer is surely some of both — and given that deflation is always and everywhere very costly, the bulk of the adjustment should in fact take the form of rising wages in Germany rather than falling wages in Spain."

And amidst this gloom, hiking interest rates to ward off inflationary pressures is only going to amplify the woes,

"But what the ECB is in effect signaling is that no inflation in Germany will be tolerated, placing all of the burden of adjustment on deflation in the periphery. From the beginning, euroskeptics worried about one-size-fits-all monetary policy; but what we’re getting is worse: one-size-fits-one, Germany first and only. That’s a recipe for a prolonged, painful slump in the periphery; large defaults, almost surely; a great deal of bitterness; and a significantly increased probability of a euro crackup."

The European policy makers are clearly missing the woods for the trees. They fail to see the competitiveness mismatch and see inflation and lack of market confidence as the problems. Accordingly, their prescription is to raise interest rates and implement austerity measures to regain market confidence. Unfortunately, the first will merely widen the competitiveness mismatch while the second, from evidence of Ireland, UK, and Greece so far, will do little to bring back the "confidence fairy".

Update 1 (12/4/2011)

Paul Krugman makes another interesting point about how the sudden convergence of interest rates in the aftermath of the introduction of the Euro has contributed to the crisis.



He writes that as the euro became a done deal, countries that had previously had to pay a large interest premium found themselves able to borrow on the same terms as Germany; this translated into a big fall in their cost of capital. The result was bubbles, inflation, and the crisis in the aftermath of the bubbles and inflation.

Update 1 (22/4/2011)

The graphic below captures the problems for the peripheral economies. Note the high external debt-GDP ratios and banking sector share of that debt.

The changing role of central banking

Standard economic models define the role of central bankers as managing price stability, as manifested by inflation rates, through the conventional interest rates-based monetary policy actions. Accordingly, inflation targeting has been the guiding monetary policy framework for a generation of central bankers.

The sub-prime crisis and the Great Recession has naturally raised questions about this strategy. On the one hand, it has brought to the fore the issue of financial stability, while on the other, it has also raised questions about the importance of economic growth itself. What can central banks do to promote these objectives?

Whatever the earlier reluctance, the dilemma about whether central banks should go beyond inflation targeting appears to have been settled. Some central banks, like the US Federal Reserve and the Reserve Bank of India, have always explicitly considered the promotion of economic growth as part of their objective (though others like the ECB have not been sure). However, the big change has been in the embrace of financial stability as an important objective of central banking policies.

Hitherto central banks have been concerned about the prices of goods and services. The prices of financial and other tradeable assets have remained outside their surveillance radar. The sub-prime mortgage bubble (and the financial market bubbles of the last two decades) with its several incentive distortions and its disastrous contagion effects on the real economy have highlighted the importance of monitoring the prices of financial assets. It is now clear that macroeconomic stability is a function of both price and financial stability.

This expansion in the scope of central banking has naturally raised questions about the instruments in their armoury to address the three-fold challenge of price stability, financial stability, and output stabilization. Financial stability is a much deeper issue than the other two, and requires that central banks go beyond their traditional micro-prudential regulation of individual banks. They have to assess the systemic risk impact of individual banks through macro-prudential regulation.

The current crisis has also seen central banks in the developed economies deploying a variety of often extraordinary measures to get their financial markets and economies back on the recovery path. The most important of these unconventional policies have been quantitative easing, which has been embraced by many central banks. Broadly, quantitative easing refers to the generic set of policies that involved direct credit injections, liberal credit access windows, near blanket credit guarantees, collateral standard expansions/dilutions, and outright asset purchases. The result of all this, coupled with the zero-bound in interest rates, has been dramatic credit expansions with explosive growth in the balance sheets of the central banks.



In the aftermath of the sub-prime meltdown, the US Federal Reserve and Treasury responded swiftly and pumped massive amounts to bailout Wall Street. Apart from lowering interest rates to the zero-bound, these measures also included credit guarantees and unconventional quantitative easing through direct credit injections and asset purchases. The Fed emerged as an effective lender, buyer and insurer of last resort.

It is difficult to estimate the exact impact of such policies. The counterfactual is one of the most difficult riddles. All the more so when the policy itself has not delivered its ultimate objective but merely prevented the situation from getting worse. How do we know what would have been the situation now without all these extraordinary policies? How do we know that these policies, tried out in desperation, have not prevented a repeat of the Great Depression? Or how do we know what could have been, as Paul Krugman and some others have claimed, with a stronger dose of quantitative easing?

There are other equally importat issues. For long time now, economic stability has meant targeting an inflation rate of around 2%. Accordingly, central banks across the developed world have successfully managed monetary policies over the past two decades and kept inflation expectations under control. In fact, it was even being suggested that central banking has slayed the inflation demon. All the major developed economies had low inflation rates and inflation expectations when the sub-prime bubble burst.

However, that in turn posed a problem of a different kind. The low inflation also mean that the interest rates were at already low levels. This also meant that the real interest rates were at ultra-low levels. Once the bubble burst and the Great Recession took hold, the central banks aggressively cut rates even further, and the interest rates touched the zero-bound. With inflation rates remaining low and even falling further, the real interest rates fell into the negative territory. All this meant that conventional monetary policy and its primary instrument, interest rate changes, had become blunt.

This naturally raised questions about the inflation and monetary policy decisions of the pre-crisis era. What is the optimal inflation rate? Should inflation rates be targeted a little higher, so as to enable governments and central banks to have some room to maneouvre with interest rates when downturns strike? What should be the ideal interest rates during the good times?

Almost exactly a year back, the IMF Chief Economist, Olivier Blanchard waded into this debate with a landmark paper. In a major U-turn from the standard IMF orthodoxy on inflation, he advocated a higher inflation target for economies during good times. He argued that economies should target a higher inflation rate, preferably 4% (against the standard 2%), so as to leave enough room for monetary policy actions to work when recessions and downturns strike.

At a 4% inflation rate, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

However, the challenge with higher interest rates lies in balancing the central bank credibility associated with a rigid and well-communicated low inflation policy and the difficulty of anchoring inflationary expectations at a higher level of inflation. The Blanchard paper has several other important suggestions, some of which are of importance to central bankers. I have discussed them here.

More fundamentally, the recent crisis has certainly highlighted the importance of central banks, especially in crisis situations. The technical nature of their work and their ability to act immediately and without much lag, unlike their political counterparts, make them important institutions. In fact, given the centrality of the economy and the increasing importance of the central banks in macroeconomic management, it is important to re-assess the role of central banks.

Their over-sized role, even in developing economies, raises the inevitable questions about the type of over-sight that the political system should have on central banks. In the US itself there is a clear divide between those advocating much greater political control over the functioning of central banks and those demanding continuance of the central banks' autonomy.