The RBI focuses on WPI and so outside experts like the IMF who think other indices are more reliable turn around and say Indian inflation is high

When asked whether the $ 700 billion dollar package to save US banks, and the US economy, would do the trick, Mr. Bernanke replied "I don't know; and I have been wrong recently". This kind of an admission, in front of millions, can only come from a secure and first rate mind. It is time that policy makers in India would learn to practice a little humility - and learn from their mistakes for the sake of themselves, and the Indian economy.

The credit crisis has made geniuses out of most commentators. Oh, there is a liquidity crunch and therefore what needs to be done is to provide liquidity. What about the high level of interest rates in India, should we also not be reducing them, and reducing them drastically? You got to be joking, is the refrain of the experts. With credit growth at 24 percent and money supply growth at 19 percent, and inflation at 12 percent, how can you cut rates? Are you not going to cause even more inflation, cry out the we know what to do about the crisis experts? So how come there is a liquidity crunch if credit growth is so high? That falls on deaf ears, because the mind of the experts is made up - and made up by the RBI. And then when you ask the RBI as to whether it has made a mistake, the refrain is why don't you look at what the non-RBI experts are saying - don't you see, they all agree we are doing the right thing. The vicious circle continues and the forces of globalization hide the mistakes when the going is good - which was until last year.

In this two-part article about monetary policy making in India I want to comment on what has been wrong about monetary policy in India, and what can be done to put policy, and India, on the path towards stable growth and low inflation. First, and most importantly, RBI policy in India since 1991 has been of the rear-view window type i.e. backward looking, and reactive. [There is an important exception to this which occurred during the Bimal Jalan period as Governor, 1998- 2003, but that is a subject of another article. Given this exception, I will term RBI policy as the Rangarajan-Reddy or RR policy]. Monetary policy, by definition, has to be forward looking, and even then, as events in the US have shown - the US FED started anticipating the crisis as early as August of 2007 - the policy need not be successful. But a backward looking policy almost guarantees failure, in addition to being not very enlightened. Second, RR policy has used the wrong indicators on both the inputs to policy and the outputs i.e. both on what the policy should be (money supply growth) and what indicator should be used to assess the impact of policy (inflation as measured by the wholesale price index or WPI). This RR policy then feeds into the expectations of the analysts of the Indian economy, who then regurgitate the RR analysis, and mistakes.

All experts and policy makers face the problem of "identification" in making assessments: how does one know that some unknown, other cause is not causing the mistakes that are being ascribed to RR? In an absolute sense, one doesn't but there are identifying factors. And such factors are two - first, the same expert when assigned to work on a different country (and this is not a virtual expert, but rather your friendly IMF, World Bank, or pink newspaper, or investment bank representative scholar) will not use either money supply growth or WPI inflation to assess monetary policy! The second identifier is what has happened to the Indian economy prior to the world wide liquidity crisis that started in September. Since post August all bets are off regarding the causes of failure of the Indian economy, that certainly is not the case for before. Especially if one considers the last Reddy policy of increasing interest rates and the CRR on July 29th ; he even argued September 7th that if he had had his way, he would have tightened monetary policy even more!

The only other Central Bank governor making the same noises, and wrong policy, was Mr. Trichet of the ECB. He also raised rates in July and just two weeks ago claimed that the financial crisis was an exclusive American problem and that the crisis revealed both how bad American regulatory system was and how good the European central bank was. A week after this unseemly gloating based on fictitious facts, Mr. Trichet admitted that the ECB had "under- estimated" the crisis. A few days later, the ECB had to intervene to save European banks; and a few days later, Europe announced a larger than American package to save European banks! When will Indian policy makers admit that they over-estimated the strength of the Indian economy, or the non-fragility of their own banking system?

On money supply or credit growth as a primary indicator of policy direction. There is a reason why most central banks in the world do not use these two indicators as "information" - the data are very noisy and most importantly fail to provide any statistical confidence. Table 1 shows the pattern of money supply growth etc for the last 60 years. What is noteworthy is the constancy in money supply growth, the favorite policy indicator of the RBI, at 17 percent since the 1970s i.e. for the last 40 years. During this period, the world has changed, oil prices have gone up 10 to 20 fold, Indian growth rate has accelerated from 4 % GDP growth to 9 % growth, and inflation has collapsed from an 8 to 9 percent to an average of 4 to 5 percent. The government, and RBI, and RR should now ask - of what use is this indicator, and why has it been misleading itself, and the economy?

But the RR policy has been doubly flawed because of the emphasis on WPI inflation as an indicator of inflation. The circle of error goes as follows. RBI has made it clear to the world, and anybody watching, that it is looking at WPI inflation, and that also year on year (yoy) WPI inflation. As even the RBI knows, yoy inflation includes all the inflation that has happened for the last 12 months. In that sense, to follow yoy inflation is backward looking policy at its worst. Even worse is the fact that the RBI does not recognize that "outside" experts look at this error and extrapolate. How else can you explain the fact that even as prestigious a set of analysts as those at the IMF will look at India's monetary policy and say that it has been too loose over the last year?! If one looks at the latest IMF World Economic Outlook Oct. 2008, the inflation rate for India for 2008 is forecast to be 5.3 percent for the CPI and (what is likely an error) only 3.8 percent for the GDP deflator! The WEO does not supply any data on money supply growth, or WPI, for any country in the world, though it does supply data on the GDP deflator and CPI. So why does the IMF use the WPI data to determine its policy conclusion that Indian monetary policy was too loose? Accountability, anyone ?

Rear Window Economics - Parts I & II

Part II - Financial crisis, and policy choices - Time to get Real

If the IMF makes these egregious errors regarding inflation and monetary policy in India, can we blame mere analysts at prestigious investment banks, or journalists at prestigious newspapers? In an article on central banks being spurred into action in Asia, the Financial Times added the following line: "One option is an interest rate cut, a measure the RBI has been reluctant to take as it battles with 12 per cent inflation." A few days earlier, the same prestigious newspaper reported that India could not drop interest rates like the West or emerging countries like South Korea, Taiwan or Hong Kong. And why not? Because of "high inflation, volatile commodity prices, shaky fiscal positions" etc.

The FT hadn't bothered to look at the fact that every country the world, West and developing, is facing the crisis of "high inflation, volatile commodity prices, shaky fiscal positions". That Korea had just faced the worst currency crisis (the won went to 1475 day before yesterday before recovering to 1242 today; it had averaged 929 in 2007, and 1401 in 1998) since 1997 had escaped the FT's attention.

I think the FT is the best newspaper in the world; the point I want to emphasize is not that FT is in error, but that the RBI is hugely in error. The journalists and experts do not have the time, or the inclination, to question what a Central Bank is saying; if it says that inflation is 12 percent and therefore rates cannot be cut, who are we to question this wisdom? And if in Korea they say that the rate cut of 100 basis point is justified, then the experts report the same. (Policy makers also note - the markets are applauding rate cuts because they see rate cuts as a sign of non- ostrich, pro-growth policy).

This is a central feature of the failure of RBI/RR policies - they have not led the market, and when they have led, they have led it in the wrong direction. Let us look at the all important topic of inflation. Has inflation in India been excessively higher than that of other countries? Data on inflation and interest rates is reported for several countries. The most inappropriate data, yoy PPI (or WPI) inflation in India is about the same as Korea, and about 3 percentage points higher than the US and Western Europe. The month on month PPI rate for India, at 0.2 percent, is also respectable, as are the data on other indicators. If one looks at the IMF provided estimate of GDP deflator inflation (seems that the IMF has not incorporated the latest data) for the various countries, India again comes out with relatively average inflation, and average for most developing countries. So where is the excess inflation that the RBI sees as too high to reduce interest rates?

What is more revealing as a (tragic) indicator of how inappropriate the RR policy of responding to yoy WPI inflation is the relationship between domestic GDP deflator based inflation (the indicator with the widest coverage) and world inflation (measured as the median of GDP deflator inflation in the world). By definition, a different country may be the median in different years. Most people will think of this inflation rate as noise, though it is as exogenous to Indian inflation as one can possibly get. The relationship between the two is very close, and has been close for the last 25 years (correlation coefficient of 0.82). The chart clearly shows that world inflation is a better predictor of Indian inflation than any tool the RBI has in its armory. It also shows that deducing that Indian inflation trends are determined by the domestic business cycle (over heating anyone?) is erroneous, at best. And anybody hinting that the domestic fiscal deficits have contributed to this inflation will only compound the error. Except for the last three years, the fiscal deficit has been trending upward since the mid 1990s and the inflation rate has trended downward.

Real interest rates in India have been inordinately high for the last two years, and have caused Indian growth rate to slow down far more than warranted. The industrial production data for April-August 2008 showed that the IIP growth rate for August at 1.3 percent, yoy, is one of the worst performances on record. As is the April-August growth rate of 4.9 percent. This rate is the fourth lowest April-August growth since 1992. This has happened over the last year and well before the world wide credit crunch or worldwide liquidity crisis. If the RBI had not been so backward looking and preoccupied with its notions of what causes inflation (no research document of the RBI has yet documented any relationship between money supply growth and inflation), it would have seen that monetary conditions had been unnecessarily hawkish as much as a year earlier. Part of the liquidity crisis that the government has identified as being due to world phenomena is in part due to real credit growth having declined precipitously in 2007 and 2008. Real non food credit growth (with nominal growth deflated by the GDP deflator) was 17.7 percent in 2007; for 2008 it is running at a low rate of 15.3 percent per annum. For the previous five years, 2002 to 2006, it had averaged 22 percent per annum. In the last year, real credit growth is appearing higher than it actually is because of the outsized inflation in oil, metals, and commodities.

A forward looking RBI would look at all indicators of inflation, and especially indicators pertaining to seasonally adjusted inflation. These data are routinely published for the US, and analysts publish, and use, seasonally adjusted data for most countries. RBI's own staff has published papers on seasonally adjusted inflation data. But since the RBI bosses do not use these data (and why not?) the outside experts do not use these data as well. But such data point to the following danger for the Indian economy - slow growth and even slower inflation. For the last three months, unadjusted WPI inflation has been proceeding at a rate of 6.1 percent per annum; the seasonally adjusted data shows an annualized rate of only 3.6 percent. Yes, inflation over the last quarter has been a low 3.6 percent.

What are the lessons and implications for RBI policy ? There is a change of the guard and now is the best time to put in place policies that help solve some of the problems facing the Indian economy. First, stop using yoy data on WPI inflation - announce that henceforth all indicators of inflation, especially seasonally adjusted inflation, will be looked at in the formulation of policy. Second, state that in this age of transparency, the RBI itself will move towards being open. The minutes of the meetings to decide policy (if no meetings are held, start holding them) should be made public, as should the minutes of the Technical Advisory Group on monetary policy. This will prevent trigger happy decisions and make everybody in the system more accountable. Third, start using, for policy formulation, some of RBI's own research on various policy issues.

These are all long-term solutions. What should the RBI do now? First and foremost it should recognize the problem for what it is - a domestically created problem exaggerated by the global financial crisis. The problem is both of liquidity and interest rates (though there are some wannabe experts, in the media and elsewhere, who do not have the skills, or inclination, to question RBI's erroneous thinking, and do not want to distinguish between the two). Real interest rates in India are too high, and have been so for the last year. Second, the RBI should recognize that what it has done so far - cutting the CRR by 150 basis points - is too little. The CRR needs to be cut by another 500 basis points over the next three months. The repo rate should be cut by 100 basis points immediately and an announcement made, that provided inflation is low (point out that commodity prices, including oil, are down more than 50 percent from their peaks) the real repo rate will be kept in consonant with the world rate, where the world is defined as our competitors. In times of global and domestic crisis, the real overnight rate should be around 0 to -2 percent. Given that inflation (expected and actual) is unlikely to be more than 5 percent for the next year, this means a decline in the repo rate of at least 400 to 500 basis points. The only way for the RBI to awake from its stupor is for it to get real i.e. understand the real economy, and the importance of real interest rates.