The arcane ways of the MPC

Last week the RBI decided not to increase interest rates. Lowering them was of course out of the question because of the fear of inflation.

Some experts said “well done, lads”. Other experts were scornful. On the whole it was a draw, soon to be forgotten.

The overall consensus, however, is that the RBI — or at least the Monetary Policy Committee (MPC) — is willing to live with higher inflation to deliver some growth because the general election is a year away.

Strangely, the entire Committee thought so whence the rare unanimity.

This episode reminded me of a saying in English, “flying by the seat of your pants”. I first heard it in 1979 when an English acquaintance of mine used it to describe Indian pilots. I thought he meant they were being very skillful.

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Later it turned out to mean the exact opposite. The Cambridge dictionary says it means “to do something difficult without the necessary skill or experience”. Another says it means improvisation.

Globally now the way central banks go about setting interest rates fits this description perfectly. I once asked an RBI governor how he did it. “If the morning tea tasted good, I lowered it. If it didn’t, I increased it”, he said.

He wasn’t quite joking. It was his way of saying it was what in statistics is called a Bernoulli Trial, like tossing a coin. These have a 50:50 chance of one of two events happening.

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The real question today, therefore, is if the MPC has made a difference to the earlier practices and outcomes. The short answer is that it hasn’t. The Committee, I think, also flies by the seat of its pants.

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For the last five years I have been asking economists and others that if the RBI had dropped interest rates to near zero, would private industrial investment in India by Indian firms have revived. No one knows for sure.

Public investments

The truth is that in India, even after all the reforms since 1991, it is still public investment that matters. In the last five years, it’s the only thing that’s kept things going because both private consumption and private investment have been on vacation.

Thus, consumption expenditure as a percentage of GDP in 2014-15 was 57 per cent. In 2022-23, according to the second advance estimates, it is 58.5 per cent. Private investment as a percentage of GDP was 27 per cent in 2014 and it is 28 per cent now.

That’s why public investment, which cares two hoots about monetary policy, has stepped in. It doesn’t really care about the price of money. Interest payments in budgets remain remarkably steady. But let’s get back to the main thing, inflation. The theory is that the price of money has a lot to do with it. Low interest rates can lead to higher inflation and vice versa.

That’s true but we need to be asking if the linkage has weakened. If so, how much. On available evidence it looks as if it is less than it used to be.

Could this be because our price data is hugely inadequate or even inaccurate? Or is it because of supply side factors? I don’t think we know enough about this.

In India the orthodox theories of interest rate-inflation come up against another problem: the size of the informal economy. By definition we know very little about it. So how do we persist in thinking that the orthodoxy works? How can we tell future prices?

The RBI has excellent convening power. It needs to form a committee like the first monetary policy committee of the mid-1980s to think about these issues.