the curious case of the policy rate cut - the hindu

3/11/2015 ThecuriouscaseofthepolicyratecutTheHindu

http://www.thehindu.com/todayspaper/tpopinion/thecuriouscaseofthepolicyratecut/article6979889.ece 1/2

Today'sPaperOPINION

Thecuriouscaseofthepolicyratecut

AnupamManurFlexibleinflationtargetingwillbringintransparency,accountabilityandpredictability.Thesurprisepolicyratecutisnoneofthethree

PROMISING:TheRBIbecominganinflationnutterisnottheproblemitisanencouragingsign.PictureshowsthebanksheadquartersinMumbai.PHOTO:PAULNORONHA

TheMinistryofFinanceannouncedthatithadcometoanagreementwiththeReserveBankofIndia(RBI)regardingtheoperationaltargetandprocedureformaintainingpricestabilityinIndia,enforcingtherecommendationsoftheUrjitPatelcommitteeonMonetaryPolicyReform.Inbrief,theRBIhasadoptedaflexibleinflationtargetingregime,wheretheCentralBankdecidesanddeclaresatargetforinflationusuallywithinarange.ThetargetratefortheRBIis4percentCPIcombinedinflationwitharangeofplusorminus2percent.TheagreementalsoincorporatesfailurenormsfortheRBI:ifinflationisabove6percentorbelow2percentforthreeconsecutivequarters,itisdeemedtohavefailed,anditisrequiredtostatethereasonsforitsfailureandtheremedialactionsitproposes.

Inanothersurprisingannouncement,RBIcutthepolicyrateonMarch4from7.75percentto7.5percent.Itisbothsurprisingandselfdefeating.ThemarketsgavetheirapprovalwiththeSensexrisingby400pointstobreachthehistorical29,000barrierintheearlyhoursofMarch4morning.ThepressreleasebyRBIGovernorRaghuramRajanstatedthatthedecisiontocutthereporatewastakenonthebasisofeasinginflation(5.1percentinJanuary)andpromiseoffiscalconsolidation.ThedataonMonthlyCPIinflationistoonoisyformonetarypolicydecisions.AnincreaseintheglobalcrudeoilpriceorrisingfoodpricescanleadtoanincreasedCPIinflation.Crucially,animportantvariabletoconsideristheRBIsownquarterlysurveyofinflationexpectationsofhouseholds.Inflationexpectations,thoughfalling,stillremainstubbornlyhighataround9percentandhavebeenabove10percentforthepreviousfewquarters.

Perplexingtiming

Further,thetimingoftheratecutishighlyperplexing.Insteadofusingitsnormalwindowforpolicyannouncements,RBIcutthepolicyrateoutofturnonJanuary15andagainonMarch4.Thedecisiontoadoptasystemofflexibleinflationtargetingissupposedtobringinaregimeoftransparency,accountabilityandpredictability.AfewdayslaterMr.Rajanhasunpredictablycutrates,whichwillonlyleadtospeculationsaboutpoliticalmachinations.

Thesurpriseratecutaside,amovetoflexibleinflationtargetingcanbroadlybesaidtobegood,contingentupontheoperationalefficiencyoftheRBI.Itisthepredominantmodusoperandiofcentralbanksaroundtheworld,andsomethingthattheRBIhasbeeninformallydoingforthepastyear.Flexibleinflationtargeting,alongwiththefailurenorms,wouldmaketheRBImoreaccountable,withouthamperingitsindependence.ItwouldalsoinfuseanappreciableleveloftransparencyinRBIsdecisionsandthisisalwaysawelcomesignforthemarkets.BusinessescantakemoreinformeddecisionsandbeabletopredicttheRBIsmoves.ThemaincriticismfromafewquartersisthatitwouldmaketheRBIinflationnuttersatermcoinedbyformerGovernorofBankofEnglandMervynKingin1997andthus,puttinggrowthonthebackburner.

Themainargumentbydeterrentsisthatwhencentralbanksbecometooobsessedwithinflation,theywilltendtoignoretheeconomysgrowth.Ifasituationariseswhereinflationstartstoincrease,RBIwillbeforcedtoraiseinterestrates,irrespectiveofthestageofbusinesscyclethattheeconomyisin.Thiscouldbedangerousinasituationifgrowthislow(asithasbeeninIndiaforthepastfewyears)andeveninasituationwheretheeconomyisjustabouttomakeanupturn(asitisinIndianow).

Nevertheless,theRBIbecominganinflationnutter(oramilderversionofit)isnottheproblem.Itisanencouragingsign.Thisisthefirsttimeinrecentyearsthatithasbeenpubliclystatedthatthefirstandprimaryroleofthecentralbankispricestabilityandnotapolicygearedtowardsencouragingoutput.MiltonFriedmanstronglyurgedthatthecentralbankcannotcontroltherealvariableslikegrowthandunemploymentinthelongrunduetothenaturalrateofunemploymenthypothesis.Instead,therightfulfunctionofthecentralbankistocontrolthepricelevel,nominalexchangerateandmoneysupply,ofwhichthepricelevelisthemostimportant.Further,havingalowtomoderatelevelofinflation,say34percent(theRBIscomfortzone)ishighlybeneficialtogrowthinthelongrun,asnumerousempiricalstudieshaveshown.Aneconomywithlowinflationisstableandconducivetobusinessandconsumers.

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3/11/2015 ThecuriouscaseofthepolicyratecutTheHindu

http://www.thehindu.com/todayspaper/tpopinion/thecuriouscaseofthepolicyratecut/article6979889.ece 2/2

Reactivepolicychanges

Therealdangerfromapolicyofinflationtargeting,asanoldarticlebyProfessorVivekMoorthysuggests,isthatofreactivepolicychanges.Apolicyratechangeshouldnotbeakneejerkreactiontojustthechangesindataofthepricelevels.Inflationtendstoshowitselfinthedatawithanappreciablelagofafewquartersorevenyears.Ittakestimeforcontractstogetrevisedandforpricestochange.Thegrowthmomentumprecedestheinflationspiral,aswesawinIndia.ThedoubledigitCPIinflationinthisdecadecamesignificantlylaterthanthespectaculargrowthofIndia(aboveitspotentialGDP)inthepreviousone.Instead,thecentralbankshouldbepreemptiveinitsstrikesagainstinflationbylookingatawiderrangeofdata.

Thus,aprematurereactivedecreaseinthereporatebytheRBIisgoingagainstthepromiseofpredictabilitygivenbytheinflationtargetingregime.TheRBIshouldwaitforlongertermdecreasesininflationexpectationsandwatchforalesserfrequencymetricsuchasathreemonthmovingaverageofConsumerPrices.

(AnupamManurisaResearchAssociateattheTakshashilaInstitution,anindependentthinktankandschoolofpublicpolicy.)

AprematurereactivedecreaseinthereporatebytheRBIisgoingagainstthepromiseofpredictabilitygivenbytheinflationtargetingregime

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