|RBI doubts on policy?|
|Wednesday, 17 August 2016 05:10|
Prime minister Narendra Modi may have spoken enthusiastically in his Independence Day speech of the monetary policy framework agreement between the government and RBI, but some of those associated with it in RBI appear to be having second thoughts about its efficacy in controlling inflation. A recent IMF working paper—this does not represent the views of the IMF—by Prachi Mishra, Peter Montiel and Rajeswari Sengupta voices some of these concerns. Mishra, who used to be a senior economist with IMF, joined RBI under Rajan as a specialist advisor in the research division; Montiel was a member of the Urjit Patel Committee that recommended inflation-targeting and Sengupta is at the IGIDR, the research institute established and funded by RBI. At the outset, the authors point out, correctly, that cross-country differences in the effectiveness of monetary transmission are very important and the channels through which central bank action affects aggregate demand are critically dependent upon each country’s financial structure—this includes the degree to which its markets are interlinked with global ones, the size and composition of its formal financial sector, the liquidity of its markets for real assets, etc, which, as the authors say, “differ significantly among countries”.
There is no reason, they say, “to expect that mechanisms of monetary transmission in low-income countries would be similar to those that have been found to operate in high-income ones”. Monetary transmission, needless to say, is critical to inflation-targeting succeeding. India’s small formal financial sector, the authors say, “limits the reach of monetary policy, thus reducing its impact on the economy” —in other words, “it is therefore clear that India operates in a very different domestic financial environment than that which tends to characterize advanced and emerging economies”. A 25 bps hike in the repo, the authors find, is typically associated with a hike in bank rates of just around 10bps. Our results, the paper concludes, “provide no support for the second step of monetary transmission, or any effect of monetary policy shocks on aggregate demand, as recorded either in the IIP gap or the inflation rate”. The low degree of financial integration with the world is cited as a reason for why the interest rate defence doesn’t work well through the exchange rate channel and the small formal financial sector for the low impact of bank lending on aggregate demand. Since much of this is well-known, as is the fact that food-inflation is mostly supply-driven and not amenable to interest rate hikes, what’s not clear is why these worthies—and that includes Governor Rajan—never pointed this out earlier; for the record, FE has opposed inflation-targeting. Under the circumstances, the next Governor and the first monetary policy committee would do well to interpret the target liberally—the middle of the target may well be 4% but the upper ceiling is 6% and sticking to that is consistent with achieving the goals spelled out in the agreement.