Is Urjit Patel really a hawk?

It is taken for granted that the new Reserve Bank of India governor, Urjit Patel, is a hawkish monetary policymaker. He is expected to double down on the path set by his predecessor, Raghuram Rajan, and keep fighting inflation till the war is won. Commentaries with headlines such as ‘Inflation hawk Patel sends bulls off street’ or ‘Bonds lose steam on fears of hawkish RBI’ on his appointment seem to indicate as much.

Such characterisation follows from Patel’s work with respect to the new monetary policy framework and the January 2014 report of the eponymous committee on the subject. (Actually, if a paper that Patel wrote in 2012 that was witheringly critical of the RBI’s failure to control inflation had also been considered, one wonders what he would have been called! In that paper, Patel demonstrated that the RBI could not absolve itself of responsibility for the high inflation.)

The Government has accepted the key recommendations of this committee on an inflation rate the RBI should target and its level/range. Still, the overall legislative changes to operationalise the MPF have been put through. The fact that Patel seems to have worked closely with the relevant ministries in seeing through the legislative changes has only reinforced the perception regarding his hawkishness.

While this is all very well, there are some finer details in the January 2014 report that show that Patel may not be the obsessive inflation fighter he is made out to be. In his report, he had laid down some essential pre-conditions for the successful adoption of inflation targeting in India.

Going farther, he also wrote a technical working paper (A Lahiri and Urjit Patel, February 2016) that shows it may be almost impossible to conduct effective inflation-targeting monetary policy in the Indian environment. In it, he has recommended that the focus should shift from headline-grabbing subjects such as creating the legislative background for the MPF. Instead, it should be on removing the institutional constraints and frictions that impede monetary policy efficacy and transmission.

To be sure, the authors are not questioning the concept of inflation-targeting. They have instead raised deep questions about how effective an inflation-targeting monetary policy can be in India given the unique institutional constraints that obtain in the country.

Running a sharply focused inflation-targeting policy given these constraints would call for relatively large changes in the policy interest rate to attain the policy objective — that is, keeping CPI inflation in the range specified. If interest rates need to move by x per cent in a no-constraint free financial system, it may have to by a multiple of that in the constraint-ridden world here.

Will the various stakeholders — the Government, the general public, banks, other market players and the RBI itself — have the stomach for such large changes in policy interest rates?

The bottomline: Urjit Patel may not mechanically move interest rates if he draws the inferences from his technical work — for, according to him, given the institutional constraints and frictions in the financial system, a formulaic approach in changing rates will be counter-productive and result in inverted outcomes. (Sure, economic models are only simplified versions of the complex real world. They, nevertheless, provide inputs for the final judgment-based decision-making). Subsequently, it may just not be possible to take the heavy-handed measures that can reverse inverted outcomes.

Patel proves in his paper that cutting rates can potentially result in a shrinkage of commercial loans’ availability (that is, supply of loans will decrease) and a contraction of overall activity. That is an inverted outcome following a rate cut.

But, we are more concerned with possible rate hikes by a hawk. Patel shows in his paper that an increase in interest rates (to reverse inflation) could ironically push inflation higher given the peculiar institutional conditions and constraints in India. Chief among the constraints is the fact that the Government or fiscal authority dominates the monetary authority, the central bank. This means the Government independently sets its budget, unconcerned about how any deficits in it will be bridged.

The fiscal authority, at the first level, can borrow from the market to finance its spending. But it is not too concerned if the market’s offtake of government bonds falls short of its requirement. Given its de jure dominance over the monetary authority, it can get the central bank to monetise the shortfall. In this setting, if the central bank were to raise interest rates, the outcome will not be a straightforward rolling back of demand pressures and lower inflation down the road.

With large stocks of government bond holdings in the banking system (the SLR constraint), any increase in interest rates will undermine banking stability and, in the worst case, result in a full-blown financial crisis. The spillovers to the real economy can be very adverse.

So, what is the central bank to do?

It finds that raising interest rates to reverse inflation effectively places a limit on the demand for government bonds from the banking (financial) system.

The shortfall in demand for bonds is then made up by central bank monetisation, setting the stage for higher inflation down the road. That is seen as the lesser evil.

So, the central bank is damned — whether it cuts or raises rates — given the present institutional setting and constraints. Given this backdrop, is Urjit Patel’s hawkishness guaranteed?

It is guaranteed only if he can eliminate the deep constraints such as fiscal dominance and SLR prescriptions. The odds on that, though, may be close to zero. Also, note that politicians have already started telling Patel what to do. This is fiscal dominance by “moral suasion”.

If our assessment of Urjit Patel is correct, then Indian financial markets are in for some roller-coaster rides in the period ahead.

The writer is a Chennai-based financial consultant