Monetary Policy Dilemmas: Some RBI Perspectives

Central Bankers should take a leaf from this recent Subbarao speech given at NYU. It has been written with remarkable clarity and simplicity.

He covers so many issues and within issues sub-issues that it is difficult to really summarise them all. The first half of the speech is defending RBI’s recent monetary policy under various heads. The second half is general issues facing central banks with RBI perspective on the same. He stresses that real world problems are too complex and difficult to fit or justify in textbooks. Moreover, there are no template answers to real life policy issues. It needs both analysis and judgement.

Defending RBI:

  • Was RBI’s monetary policy in 2009-11 too hawkish or dovish? RBI has been criticised both ways recently. Some say it has been too dovish as it took baby steps to rising inflation in 2010. Some say it is too hawkish as it ha raised rates sharply leading to slowdown in the economy.Subbarao says both need to be assessed given the context RBI was in. The inflation in 2010 rose sharply around Aug as global commodity prices rose sharper than expected.  The companies in India were able to pass these rising costs to consumers leading to a more generalised inflation. However, around then there was huge uncertainity on the global outlook which again dipped post Greek crisis in May-10 and US slowdown post Aug-10. Balancing growth and inflation became the key and hence there were 25 bps hike.The dove camp also say it has been behind the curve. He says RBI has raised rates by 350 bps since Apr-10 and 500 bps if we take the shift from reverse repo to repo rate. So, not justified.

    However, from May-11 RBI has raised rates by 150 bps leading to statements it is too hawkish. Here Subba says these hikes were done as inflation was much higher than threshold level of 4-6%, above which growth starts to decline. Some say recent inflation is because of supply and RBI cannot do much about it. He says this is always difficult to assess as it is usually a combi of both demand and supply. And then we also need to look whether these supply shocks are permanent or temporary. In case they are permanent (as current supply shocks seem to be), RBI has to act.

  • Role of liquidity and why RBI keeps tight liquidity — He points that tight liquidity and tight policy stance go hand in had but sometimes things could be opposite. He points to OMOs which RBI did till Jan-11 which infused liquidity. People said this is contradictory but he says it was needed as RBI did not want liquidity to become excessive deficit. Some people understood, for others communication efforts were made.
  • Role of forward guidance: This has been one of the most interesting aspect of Subba’s career so far. The steps he has taken to improve RBI transparency in such a short time has been a real achievement. He staretd giving forward guidance in each mon pol statement which have been criticised. He makes some fascinating points defending this:
Giving forward guidance is not always necessarily a positive sum game. Central banks face several dilemmas. The first is how exactly is the conditionality surrounding the guidance to be worded. It cannot be so vague as to lose all content value; on the other hand, it cannot be so precise that the central bank becomes a prisoner of its words and loses any flexibility to deviate from the guidance should the underlying circumstances change. A second, and related, dilemma is how to ensure that the market correctly appreciates the conditionality and does not interpret the guidance as an irrevocable commitment.
He points to recent Jul-11 forward guidance which said:

“Going forward, the monetary policy stance will depend on the evolving inflation trajectory, which in turn, will be determined by trends in domestic growth and global commodity prices. A change in stance will be motivated by signs of a sustainable downturn in inflation.”

Simultaneously, we also noted that the stance of monetary policy will be to “manage the risk of growth falling significantly below trend”.

People criticised for its lack of precision. What does sustainable downturn mean? What is growth below trend?
Reading the two statements together, some analysts have criticized the guidance for its lack of precision; more specifically, there were questions like, ‘what is the trend growth rate’ and ‘how much deviation from trend would the RBI tolerate’. This was valid criticism and these questions were relevant. With our trend growth rate, post-crisis, estimated at 8 per cent, the balance of policy stance would shift if growth fell consistently and substantially below that rate. But a shift in stance will also be a function of the behaviour of the external and internal drivers of inflation. What we said in response to the criticism therefore was that defining precisely ‘what significantly below trend’ ex-ante was difficult, and that the ambiguity in the guidance was deliberate because it was unavoidable.
Central to this whole issue of forward guidance is that a central bank is handicapped by external uncertainty over which it has no control. The crisis has brought this dilemma into sharp focus. On the one hand, central banks want to use the instrumentality of forward guidance to manage expectations, and even outcomes; on the other hand, they cannot be precise enough because of external uncertainty. How to communicate monetary policy so that the benefit-cost balance is positive is yet another dilemma for central banks
🙂 This is really well explained. But now you also know RBI will act if growth forecasts fall substantially below 8%. So far it expects economy to grow around 8% in 2011-12.
General CB issues:
  • Should Central Banks target asset prices: The usual argument over  how Greenspan era of monetary policy not targeting asset prices has fallen flat post this crisis. But still central banks can’t really manage asset prices using interest rates. For this we need diff tools like macroprudential policies which again opens up many qs on who would manage these polciies. Will central bank’s independence be lost as they take on larger role etc?
  • Monetary Policy and Fiscal Policy Complex: He explains how there has been a shift in thinking from Keynesian to Monetary Policy and again back to the Keynesian world. Once again, people are asking qs like is fiscal policy undermining mon policy? Aren’t the so called unconventional monetary actions thinly veiled fiscal measures? The accepted insti framework of rule-based fiscal policy and independent central banks has been tarnished.He points  India also passed fiscal stimulus in the crisis but is struggling to roll it back. This is leading to issues for mon pol:

As India emerged from the crisis, the Government adopted a revised road map for fiscal consolidation as recommended by the Thirteenth Finance Commission. Nevertheless, meeting the road map targets is going to be a formidable challenge. The quantum of non-discretionary expenditure (salaries, pensions, interest payments) is large and this cannot be adjusted easily, at any rate in the short-term. By far the largest component of discretionary expenditure is on subsidies – on food, fertilizer and petroleum products. In reducing these subsidies, there is inevitably a tension between democratic compulsions and economic virtue. Even as the Government pursues a quantitative target, it also has to be mindful of the quality of fiscal adjustment – that is to prune unproductive expenditure and increase productive expenditure which is necessary for raising the potential output of the economy.

As I said, the Reserve Bank has been battling inflation for the last twenty months. Monetary tightening, as is well known, works by restraining demand. In as much as the fiscal stance is supportive of demand, the monetary stance has had to be more aggressive than otherwise. For monetary policy to be more supportive of growth, it will be necessary for fiscal consolidation to take root more firmly.

He nicely points out how Developed and India face different challenges:

The dilemma for monetary policy in India is thus somewhat different from that of the advanced economies. The dilemma for advanced economy central banks is whether monetary policy is having to be kept more accommodative than necessary to offset fiscal contraction. In contrast, the dilemma for the Reserve Bank is whether monetary policy is having to be tightened that much more because of fiscal demand.

In the end he says we need more 2 way communication between central banks and central bank scholars.

Superlative stuff. You may/may not agree with his defense but the clarity of his ideas are just amazing.

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