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3/11/2015 The curious case of the policy rate cut The Hindu http://www.thehindu.com/todayspaper/tpopinion/thecuriouscaseofthepolicyratecut/article6979889.ece 1/2 Today's Paper » OPINION The curious case of the policy rate cut Anupam Manur Flexible inflation targeting will bring in transparency, accountability and predictability.The surprise policy rate cut is none of the three PROMISING:“The RBI becoming an ‘inflation nutter’ is not the problem; it is an encouraging sign.” Picture shows the bank’s headquarters in Mumbai.— PHOTO: PAUL NORONHA The Ministry of Finance announced that it had come to an agreement with the Reserve Bank of India (RBI) regarding the operational target and procedure for maintaining price stability in India, enforcing the recommendations of the Urjit Patel committee on Monetary Policy Reform. In brief, the RBI has adopted a flexible inflation targeting regime, where the Central Bank decides and declares a target for inflation usually within a range. The target rate for the RBI is 4 per cent CPIcombined inflation with a range of plus or minus 2 per cent. The agreement also incorporates failure norms for the RBI: if inflation is above 6 per cent or below 2 per cent for three consecutive quarters, it is deemed to have failed, and it is required to state the reasons for its failure and the remedial actions it proposes. In another surprising announcement, RBI cut the policy rate on March 4 from 7.75 per cent to 7.5 per cent. It is both surprising and selfdefeating. The markets gave their approval with the Sensex rising by 400 points to breach the historical 29,000 barrier in the early hours of March 4 morning. The press release by RBI Governor Raghuram Rajan stated that the decision to cut the repo rate was taken on the basis of easing inflation (5.1 per cent in January) and promise of fiscal consolidation. The data on Monthly CPI inflation is too noisy for monetary policy decisions. An increase in the global crude oil price or rising food prices can lead to an increased CPI inflation. Crucially, an important variable to consider is the RBI’s own quarterly survey of inflation expectations of households. Inflation expectations, though falling, still remain stubbornly high at around 9 per cent and have been above 10 per cent for the previous few quarters. Perplexing timing Further, the timing of the rate cut is highly perplexing. Instead of using its normal window for policy announcements, RBI cut the policy rate out of turn on January 15 and again on March 4. The decision to adopt a system of flexible inflation targeting is supposed to bring in a regime of transparency, accountability and predictability. A few days later Mr. Rajan has unpredictably cut rates, which will only lead to speculations about political machinations. The surprise rate cut aside, a move to flexible inflation targeting can broadly be said to be good, contingent upon the operational efficiency of the RBI. It is the predominant modus operandi of central banks around the world, and something that the RBI has been informally doing for the past year. Flexible inflation targeting, along with the failure norms, would make the RBI more accountable, without hampering its independence. It would also infuse an appreciable level of transparency in RBI’s decisions and this is always a welcome sign for the markets. Businesses can take more informed decisions and be able to predict the RBI’s moves. The main criticism from a few quarters is that it would make the RBI “inflation nutters” — a term coined by former Governor of Bank of England Mervyn King in 1997 — and thus, putting growth on the backburner. The main argument by deterrents is that when central banks become too obsessed with inflation, they will tend to ignore the economy’s growth. If a situation arises where inflation starts to increase, RBI will be forced to raise interest rates, irrespective of the stage of business cycle that the economy is in. This could be dangerous in a situation if growth is low (as it has been in India for the past few years) and even in a situation where the economy is just about to make an upturn (as it is in India now). Nevertheless, the RBI becoming an “inflation nutter” (or a milder version of it) is not the problem. It is an encouraging sign. This is the first time in recent years that it has been publicly stated that the first and primary role of the central bank is price stability and not a policy geared towards encouraging output. Milton Friedman strongly urged that the central bank cannot control the real variables like growth and unemployment in the long run due to the natural rate of unemployment hypothesis. Instead, the rightful function of the central bank is to control the price level, nominal exchange rate and money supply, of which the price level is the most important. Further, having a low to moderate level of inflation, say 34 per cent (the RBI’s comfort zone) is highly beneficial to growth in the long run, as numerous empirical studies have shown. An economy with low inflation is stable and conducive to business and consumers.

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  • 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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