Mind the Market

Structural Change in Monetary Policy ?

By

Surjit S Bhalla

(Newswire 18 , Jan 28, 2009)

Make no mistake about it – the forthcoming Monetary Policy meeting of the RBI, Jan. 29^th, is going to be significant, and at the risk of only a very mild exaggeration, one of the most important meetings of the last decade. There are two very important policy issues confronting monetary policy – higher than expected growth and higher than comfortable level of inflation. The text-book Indian answer to this set of facts is to raise interest rates. The big question is – is there need for the traditional approach?

Let us examine the two issues separately. First, economic growth. What the text-book says is that when growth is above potential, then policy should be tightened. (I am only talking about interest rates, and not policy tightening via raising the CRR). But is a GDP growth level above 7 percent above potential? It may have been so earlier, but for the last seven years, since 2002/3, GDP growth has averaged well above 8 percent, and it did so with minimal inflation for five of those years. As is well known, and even acknowledged by the hawks at the RBI, inflation in 2008 was mostly imported i.e. it had precious little to do with monetary policy. This year, overall inflation is even higher than last year. What is going on?

In a recent paper “Measures of Inflation in India: Issues and Perspectives”, Deepak Mohanty of the RBI, examines the various inflation indices available in India. He also calculates an inflation index excluding food - for the financial year 2009/10, this “core” inflation has averaged a minus 1.2 percent. If oil is excluded along with food, the average increases to 1 percent. In conclusion – inflation in 2009/10 cannot be regarded, by any reasonable stretch of the imagination, as a monetary phenomenon. That is not to say that policy changes should not be made by the government – it is only to state that a response to high inflation should not come from the monetary authorities.

So the joint conclusion is that growth is not above potential, and excess demand hasn’t been seen via the inflation data. If this is the reality, what should the RBI do? It should change course from its traditional mode of thinking and incorporate the following facts into its system. First, inflation in India, and in most parts of the world, is a global phenomena rather than something  local monetary conditions can affect. Second, potential GDP growth in India is well in excess of 8 percent. A simple way to understand this is to appreciate the fact that investment rates have increased by about 16 percentage points (from 23 percent of GDP in 2002 and before to about 39 percent of GDP today). This is not inflation causing increase in consumption we are talking about, this is growth enhancing investment.

Third, and most importantly, real interest rates in India are too high. A comparative analysis of real long-term rates in India (prime lending rates) with countries in East Asia (our competitors) shows that real lending rates in India are higher by an average of 1.5 percentage points over the period 2002 to 2008. What the world financial crisis of 2008 did was to bring real interest rates in India down from their abnormally high levels. If analysts and policy makers think that just because real interest rates went down in 2009 they should now be brought up, then they are believing that (a) real interest rates need to be much higher in India than our competitors, and (b) that our potential GDP growth rate is south of 7 to 8 percent. Both these beliefs lack an economic or empirical basis. Hence, they should not be a basis for monetary policy.

In my view, the traditional approach to monetary policy in India is on the way out. Starting Friday, Jan. 29^th 2009, we will begin to find out.

The author is Chairman of Oxus Investments, a New Delhi PMS (hedge fund) and emerging markets advisory firm; please visit www.oxusinvestments.com  for an archive of articles etc.