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. 

India and emerging Asia compared

The annual Asian Development Outlook 2012 (pdf here), which talks about rising inequality in Asia, has some interesting graphics about the Indian economy, especially in comparison to its counterparts in emerging Asia.

Note the sharp fall in investment as a contributor to GDP growth in 2011. Though government consumption has contracted, so has private consumption. Interestingly, the share of private consumption has risen in China.  

The Reserve bank of India (RBI) has been easily the most aggressive Asian central bank. It cut interest rates vigorously when the recession struck and raised rates with similar aggression when inflationary pressures became unhinged. On the positive side, there exists considerable cushion for monetary easing if the RBI feels inflation is under control.

But inflation in India has been a persistent problem for the past four years. India's current inflation rate is more than twice that of any other major Asian economy. This means that the RBI will remain reluctant to indulge in any significant monetary easing anytime in the immediate future. At best, it is not likely to raise rates any further.  

I have blogged earlier that the inflationary pressures were clearly the result of an overheating economy. As the graphic shows, the Indian economy's scorching pace of growth in the mid-2000s blazed the economy well beyond its potential output frontier. Though growth has slowed, it is now merely at its potential output frontier. This is yet another reason why the RBI may desist from moving down the path of monetary accommodation. Massive investments to ease the supply side is the need of the hour.

However, the government appears to have limited fiscal space to play an aggressive role in any supply side easing. India is easily the most fiscally constrained country among all major Asian economies. This means that two things will have to happen simultaneously. One, fiscal spending on subsidies will have to be reined in and the savings routed into infrastructure, agriculture, human resource development and so on. Two, private investments will have to be catalyzed in large amounts. Foreign capital investments will have to supplement the domestic private partners in boosting private investment in the economy.
  

The graphic below highlights the nature of distribution of gains between labour and capital. In the period 1990-2007, while real wage rate did not even double, labor productivity increased three-fold, from about 80,000 to about 250,000 rupees. In fact,  the average annual growth rate of labour productivity was 7.4% during 1990–2007, while the average annual real wage growth rate was only 2%. This implies that gains in productivity were not passed on to wages and, consequently, the labor share of India’s organized manufacturing sector declined significantly.

Central Banks hold sway, where are the governments?

There is a common feature in the respective policy responses to the current domestic economic situations in United States and India. In both countries Central Banks are at the frontline fighting the battle, while governments appear missing in action. In many respects, both the Fed and the RBI are, in different ways and degrees, fighting not only the monetary policy but also the fiscal policy battles. This over-reach in both areas is unsustainable and is generating distortions that could set the stage for even bigger crises.

More worryingly, not only do the central banks themselves appear convinced of their leadership role, but everyone else too believes that they should keep doing more. In the process, governments are getting away lightly. Nothing can take away from the fundamental fact that only governments can sustainably bring a closure to the ongoing economic crisis and set the stage for a more sustained economic recovery.

In the US, since late 2008, the Fed has unveiled a series of policies, ranging from classic monetary policy to outright fiscal policy, to not only keep the credit market open but also to backstop aggregate demand from falling and stimulate economic growth itself. It has lowered rates to near zero and has committed to keep there till end-2014 (a period of over 6 years of extraordinary monetary accommodation), multiplied its balance sheet many-fold to over $3 trillion by purchasing a large category of assets and injecting massive quantities of liquidity, and is now experimenting with greater transparency in communicating the Fed's monetary policy processes so as to mould market expectations.

In contrast, apart from the initial stimulus plan, ARRA, the US government has largely remained at the sidelines. All this, while averting a financial meltdown and deep deflationary economic recession, has created several incentive distortions, besides postponing important adjustments. Mohamed El-Erian summed it up nicely in a recent FT op-ed,

"Despite its repeated pleas for fiscal and housing engagement, the Fed has inadvertently provided cover for other government agencies to continue avoiding difficult, but necessary, decisions. Notwithstanding these shortfalls, the Fed still feels compelled to do even more. For both moral and political reasons, it believes that it cannot be seen to stand on the sideline as the economy struggles with a deeply-entrenched unemployment crisis and political dysfunctionality – even if this means having to use even more imperfect, indirect and, increasingly, unpredictable policy measures."

Unlike in the US where economic growth and financial market stability have been the central themes, inflation and burgeoning public deficits have been the biggest concerns. RBI has been pitchforked into the frontline of the inflation battle. In turn, since the onset of the initial signs of economic strains and inflationary pressures in early 2010, the RBI has increased interest rates 13 consecutive times. In the process, it has tempered the over-heating economy and appears to have brought inflation down to more tolerable limits.

It was evident to anyone who cared to go beyong stage one that India's inflation problem was fundamentally a supply side problem and could be sustainably managed only by easing supply constraints, especially by removing infrastructure bottlenecks and increasing foodgrain production. RBI's inflation fighting policies only managed to cool the over-heating economy and bring it down to its constrained production possibility frontier.

This long-period of inflation-fighting by monetary tightening was an ideal opportunity for the government to undertake policy measures and reforms that would initiate the process of declogging the supply-side and pushing up the production possibility frontier. But nothing of that sort was forthcoming. Worse still, the government added to the problem with a series of fiscal largesse, unconcerned about the severe fiscal strains that were clearly evident.

This in turn increased government borrowings and boosted aggregate demand at a time when supply was severely constrained, therefore adding to the inflationary pressures. With interest rates rising, inflationary expectations anchored upwards and policy parlysis gripping government, investment climate weakened. Instead of expanding aggressively in a growing economy, cash rich businesses turned off their investment taps and have preferred to wait and watch.

Now, with the inflationary pressures easing, the onus is again back on the RBI to take the centerstage. Everyone calls on the RBI to lower interest rates to encourage investment. Critics accuse it of being "behind the curve" in lowering rates, just as it was accused of being similarly slow to raise rates in the first place as the recession struck.

For sure, in the coming months, the RBI will lower rates and cost of capital will come down. Businesses will start investing and economic growth will recover somewhat. But all that will be pyrrhic victories if interest rate cuts are not accompanied with policy reforms to ease supply constraints. In its absence, we will witness another short-cycle of boom followed by over-heating and slowdown. The RBI will again be forced to step in an re-enact its current role.

Markets and central banks alone cannot set the foundations for economic growth. Governments have a critical role to play in laying the policy framework for expanding the economy's production possibility frontier. Markets thrive on the enabling policy environment established by public policy actions. Paralysed governments, which cede responsibility to technocratic institutions like central banks, are merely kicking the can down the road.

Satyajit das has an excellent article in FT which outlines the distortions caused by a prolonged period of ultra-low interest rates.

Update 1 (30/4/2012)

An excellent FT op-ed on how leveraging central bank balance sheet has come to be seen as the least costless route out of a financial crisis induced recession. The unprecedented liquidity injections have undoubtedly helped backstop the lurch into full-blow depressions. By early 2009, the Fed, the ECB and the BoE had all cut their main policy rates to all-time lows, and it has remained there since. However, the challenge for central banks is not to manage the retreat from these accommodatory policies before stoking inflationary pressures and without suffering massive losses.

The use of the balance sheet as a policy tool is no longer likely to be considered unconventional. The crisis has moved it to the centre.

 

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.

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 "framing effect" and monetary policy

In its quarterly monetary policy review, the Reserve Bank of India (RBI) has raised its benchmark repo rate (the rate at which it lends money to commercial banks) by 50 basis points to 8%, its 11th successive increase since October 2009.

In the accompanying statement, the RBI expressed heightened concerns at inflationary expectations getting unleashed. It argued that inflation was a far bigger concern than any slowdown in economic growth. In simple terms, as the RBI Governor's press statement indicates, the main thrust of the interest rate decision was to "moderate inflation and anchor inflation expectations".

Given this "inflation targeting" based paradigm in central bank communication, the rate hike has expectedly raised concerns about its adverse impact on economic growth. It is argued that the increased cost of borrowing would discourage investments and slow down growth. Further, they also claim that since the inflation is driven by supply-side causes, monetary policy actions will have little impact on the final outcomes. This view is based on the valid assumption of an inflation-growth trade-off.

However, a different, "over-heating economy" paradigm based central bank communication could give a different spin to this interest rate decision. It is common knowledge, and the RBI statement reiterates this, that inflation in India is caused by supply constraints. The growth on the supply-side of the economy is simply unable to keep pace with demand growth. These constraints include infrastructure bottlenecks, slow growth in manufacturing production capacity and agriculture production etc.

In the circumstances, there are only two options - ease supply-side constraints and/or slow down demand growth. Since the former is a medium to long-term challenge, the only alternative is to cool-down the economic growth. In this context, the objective of the RBI's rate hike decision becomes one of deliberately cooling down an over-heating economy. The interest rate hike has the desired contractionary effect on the economy. In this monetary policy communication paradigm, lowering growth, and not inflation, is the direct objective. If this is the objective, then the inflation-growth trade-off loses its relevance, with the balance tipping decisively in one direction.

This debate is a classic case of what behavioural economists call "framing effect". Substantively, both "inflation targeting" and "cooling the overheating economy" based monetary policy decisions amount to the same. However, when framed in terms of the former, concerns about growth come to the fore, forcing governments into criticising the central bank. In contrast, when framed in terms of the latter, where slowing down growth is the explicit objective, the criticism of the central bank is likely to be more muted.

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.