The RBI’s July 30 Monetary Policy Review has maintained a predictable ‘status quo’.
This ‘status quo’ comes after the RBI had already ‘reviewed’ its policy twice earlier this month and imposed a series of ‘indirect’ liquidity tightening measures.
The RBI has further clarified its stance as one of ‘active liquidity management...consistent with the growth-inflation balance and macro-financial stability’. Thus, going forward, we may anticipate further monetary tightening – either through direct or indirect measures.
The RBI provides the rationale for such tightening in terms of supporting the rupee. Analysts base their prescription for monetary tightening on the application of Taylor Rule benchmarks to the Indian case to arrive at a higher ‘correct’ or desirable policy rate.
While the case for a restrictive monetary policy to correct the weak rupee is flawed, given that such weakness has more to do with economic fundamentals, what about the logic for raising policy rates to the Taylor recommended levels?
The Taylor Rule provides central banks a rule to set short-term interest rates as economic conditions change, so as to maintain economic stability and the desired inflation.
It prescribes monetary tightening or loosening based on the observed deviations of the actual output and inflation from the potential/desired levels. Analysts have applied this rule to the Indian case — with its lower output and higher inflation than desired levels — to call for monetary tightening.
Three recent reports – Nomura, Goldman Sachs and IMF — have suggested that policy rates in India have been lower than the Taylor benchmarks.
Nomura has categorised India in the ‘high risk zone category’ and warned that ‘without less accommodative monetary policies to rein in debt and property markets, and a step up of structural reforms to boost productivity-enhancing supply’, there could be a crisis in the next few years. It has blamed loose monetary policies for the deteriorating economic fundamentals. The message is loud and clear: Tighten or face the consequences.
However, should the ‘Taylor Rule’ constitute the Holy Grail for determining monetary policy stance and even if so, are we missing out on some important factors?
THE TAYLOR RULE
What seems to have been ignored is the role of the third factor, apart from output and inflation, namely, the real equilibrium interest rates, in determination of policy rates. Is it possible that the ‘lower’ policy rates may be on account of this third factor?
The calculation of the real equilibrium interest rates is a ‘complex issue, as it is not observable in real time’ (RBI, 2013). By analysing the factors determining interest rates, however, we can estimate the direction in which these rates may have moved.
Table 1 tracks the trends in growth rates of domestic savings and investments — the determinants of equilibrium interest rates — over the period 2004-05 to 2011-12. While both savings and investment rates have fallen from the peak in 2007-08 (the pre-crisis period), the fall in savings rate has been greater.
This may explain a lower equilibrium interest rate. The quality of investment has also deteriorated.
From the asset market side, other factors such as the greater demand for physical assets and a greater capital price risk may have also driven down the long run risk-free interest rate levels.
Thus, despite the difficulty in estimating real interest rates, we may not be wrong in our assessment that real equilibrium interest rates may have moved downwards, especially in the post-crisis period, leading to lower observed policy rates, compared with the Taylor Rule benchmarks.
In such a scenario, how valid would it be to increase policy rates without attention to the factors lowering real interest rates (savings and investment) in the first place? What are the policy implications of this finding?
POLICY IMPLICATIONS
The Standard Taylor Rule, based on the deviations in the output gap and the inflation gap, would advocate a tightening monetary policy stance.
This may however be counterproductive, given the trends in savings and investment in India.
With household financial savings having come down at the cost of physical savings and corporate sector investment having declined, a tightening monetary stance may only exacerbate the problem of growth and inflation, by adversely affecting savings and investment further.
Another problem with the Taylor Rule is that it implicitly assigns equal weightages to the growth and inflation objectives, which may not be applicable to the Indian case.
Thus, while you may still get your bets right in predicting a tighter monetary policy going forward, notwithstanding the current status quo, the question is: Is the RBI getting it right as well?
Given that such a policy may have a differential impact on the output and inflation dynamics, we may well have to wait and watch.
The author is a Professor at SP Jain Institute of Management & Research, Mumbai.