The RBI finds itself in a fix. Inflation rules above its comfort level and growth has slowed down significantly, despite its hawkish stance in the last three-and-a-half years. Notwithstanding the growth tune that it plays intermittently, the RBI’s primary concern has been inflation control. True, as the central bank, it has the mandate to ensure price stability in the economy. However, unlike in some other countries where the central bank has an explicit mandate to keep inflation within a certain target, India follows a broader approach to inflation management.

The RBI traditionally calibrates policy, taking a balanced view of the growth and inflation situation in the economy. However, the RBI seems to have been driven by an inflation obsession since 2010, but without much success. Evidence to this effect can be seen from the various theories the RBI has put forth to justify its tight monetary stance.

Despite the 13 straight rates hikes between March 2010 and April 2012 and a hawkish stance now and then, the headline inflation eludes the central bank’s comfort level. In the last three years, the RBI top brass have offered four different justifications for the tight money stance. First, they came up with the sacrifice story, then the low real interest story, followed by the expectations theory, and now the illusory neutral interest rate stance. The RBI seems to be using all tricks at its command to justify rate hikes — all for the sake of the poor.

Sacrifice Theory

By maintaining that some growth had to be sacrificed in the fight against inflation, the RBI Governor popularised the sacrifice story. He was referring to the need to ease demand-side pressure on inflation with higher interest rates. . However, in the process of tightening, growth slowed down significantly without visible decline in inflation. What was overlooked was the fact that the pressure on prices was on account of supply-side constraints.

Real-Nominal rates

When interest rates increased successively for about a year, the RBI faced pressure from the Government and industry to lower rates. The decline in investments was attributed to higher rates. The central bank countered these criticisms by floating the low real interest rate story.

The real interest rates during the high growth phase were compared to the post-2010 phase. During the high growth phase of 2004-08, real interest rates averaged more than 7 per cent compared to less than 4 per cent during 2010-11 and 2011-12 when growth showed visible signs of weakness.

Thus, the RBI attributed the slowdown in economic activity to structural bottlenecks and governance-related issues rather than higher interest rates.

While this assertion from the central bank is true, it is also a fact that loans are priced in terms of nominal interest rates and high nominal rates led to higher NPAs. This, in turn, made banks shy of lending, depriving deserving sectors of the economy of credit. Further, it is a matter of debate as to what extent real interest rates matter in an economy dominated by the services sector. When high nominal rates ultimately resulted in higher delinquency, the RBI attributed them to poor loan management and inefficiency of the banks.

When the pressure built up on the RBI to reverse its tight money policy, the Governor said that since inflation hurts the poor the most, the central bank is keeping interest rates high as it wants to help them. What was ignored in this storyline was that rural wages had grown smartly in the last few years, thanks to the MNREGA initiative of the government. The purchasing power of the poor had improved.

Justifying higher rates

The RBI was still not done with higher interest rates in its zeal to control inflation, notwithstanding the fact that food prices were contributing to higher WPI and CPI inflation. To justify the higher interest rates — knowing well that monetary policy was being ineffective in controlling inflation that is rooted in a poor supply response — the RBI mooted the expectations theory with a tinge of the counter-factual.

The RBI felt that unless interest rates were kept high, food inflation would get generalised, as people would expect higher inflation. High rates are meant to convey that the RBI is serious about inflation. The counter factual to this was that, had interest rates not been kept at a high level, inflation would have been much higher. However, it is a different matter that inflationary expectations have remained at very high levels, despite the rate hikes.

Neutral Stance Theory

Now, the new Governor has added his own justification for a hardening bias, by stating that the central bank will pursue a neutral monetary stance. The neutral rate of interest concept is more closely associated with the Taylor rule, a popular version of rule-based monetary policy. This is the rate that will neither have an expansionary or contractionary bias. In other words, the policy rate will neither boost nor try to dampen growth.

The Taylor rule depends on many variables, on which there is more confusion than clarity.

One has to form an idea about the real interest rate, the potential growth rate and the acceptable level of inflation to arrive at the neutral rate. Different perspectives on these crucial macro variables will give a range of neutral interest rates rather than a specific neutral rate. In the past the RBI has been shifting the policy anchor from WPI to CPI to justify a particular rate action. The use of neutral rate will give the RBI the space to justify a further rate hike, if it chooses to do so.

While inflation management is clearly important, growth concerns should receive equal attention from the central bank. The RBI should not forget that in a supply constrained economy, poor growth will only aggravate the inflation problem. However, this in no way absolves the government of its responsibility to pursue growth supportive policies. The RBI on its own can only partly do justice to take the economy to a high growth and low inflation environment.

(The author is Professor of Economics, Xavier Institute of Management, Bhubaneswar. The views are personal.)

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