The RBI has been too cautious

The Reserve Bank has decided to retain its policy rates and reserve ratios. Although favourable winds are blowing both domestically and globally, it does not want to take the risk of changing its course a few weeks down the line because of changed adverse circumstances.

The trends are partly favourable and partly not but their mixed nature has imparted a note of caution on the policy. But the basic question arises: How long can the bank wait for clear signals that can facilitate a relaxation in policy?

Unlike in the distant past, when economic trends were clear, the global economy now is complicated and integrated.

Trends can change so dramatically overnight due to the information revolution that the distinction between risk and uncertainty is no longer as reliable as in the past. The former is supposed to be measurable or for facilitating pre-emptive action while the latter is not.

All that the central bank can do is carry out certain types of Monte Carlo exercises attaching arbitrary probabilities to the outcome based on the current knowledge to get an idea of where the economy is moving. Like many individuals in the world, the central bank has also to learn to live from day to day, adapting itself to changing circumstances. The policy of ‘When in doubt do not make changes in policy’ may not be always a wise course to adopt.

There were some interesting statements made, especially at the post-policy press meet of the RBI governor, Raghuram Rajan.

In the first place, a hope is held out that if the disinflationary process continues there could be a relaxation in policy early next year. What is more important is that there is a clear statement that the post-2016 inflation target of 4 per cent is acceptable to the government. This is refreshing after so much talk about a new normal of 6 per cent for inflation.

But the repeated emphasis on the base factor deciding the course of inflation is disconcerting coming as it does from the well-qualified and competent researchers of the econometric division, which this writer had the privilege of heading as its first director when it was shifted from the Department of Statistical Analysis to the Department of Economic Analysis and Policy.

Ridiculous stance

I have not seen any econometric study in internationally recognised and prestigious professional journals where the base effect is captured in an inflation model to know its influence on the general course of price rise.

In fact, it is ridiculous. If the base is high then it is a good thing for the future, for inflation rates may come down a year from now and hence no monetary policy needs to be adopted! If the index base is low now then it is bad because one year from now, ceteris paribus , inflation rate will be high. So action should be taken to raise the price rises in the economy!

Yet another satisfactory feature of the policy statement is the continued absence of any reference to the concept of core inflation, as applied in the West. There is only a sedate reference to “non-food non-fuel economy”. There are no references to any money supply and deposit targets that had relevance when monetarism ruled the day. It is no longer so now. There is a statement that a rise in investment is critical for a sustained pick-up in overall economic activity. This is true only for the future.

Today’s massive investments in infrastructural and industrial activities will bear fruit after several years. In the meantime, money would have been pumped into the economy without a commensurate rise in output in the immediate future, leading to inflation.

I discovered this in the course of a project appraisal study in the 1970s in Bellary district to advance loans to farmers for land reclamation with support from the National Bank for Agriculture and Rural Development (Nabard). The lands were going to benefit from the massive Tungabhadra irrigation project after more than two decades. Local prices had gone up in the meantime.

So emphasis on massive investment in infrastructural projects to raise GDP is sound in principle. However, in view of the time-lags involved, the authorities should concentrate also on projects that are quick-yielding.

The Green Revolution was successful because of the massive minor irrigation programmes (for example, digging wells/tube wells) that took place in Punjab and other States within a short period.

There is a statement that open market operations are undertaken not with a view to influencing long-term interest rates.

Still when buybacks of government securities take place the idea is to groom the market in favour of the gilts.

In the first few decades after Independence, there was an inverted yield curve with long-term loans fetching lower interest rates than short-term ones. The idea was to encourage lending for investment purposes.

With the reforms in monetary policy now, the rates are supposed to be market-determined. Can the RBI leave the long-term rates alone concentrating only on short-term rates?

The entrepreneur undertaking an investment will compare the internal rate of return with the rate of interest to find out whether it is worthwhile to go for a loan for the purpose.

In the US, the central bank concentrates on the short-term end of loans because market integration is complete and the changes in short rates will reflect in the long rates also. It is time the RBI undertakes a study to determine the interface between the short and long term rates to formulate a good policy.

The writer is a Mumbai-based economic consultant