There are two issues in monetary policy on which the RBI is silent — the ‘impossible trinity’ problem and the effect of lowering interest rates on capital markets. The former basically means that a fixed exchange rate, free capital flows and an independent monetary policy that caters to the domestic economy cannot co-exist -- one of these has to give. In India’s case, given the fairly free flows, the choice lies between using the interest rate to control the exchange rate or the domestic economy.
In mid-2013, soon after Raghuram Rajan took over as governor, interest rates were raised to prevent capital outflows and stabilise the rupee. While it is hard to assess the responsiveness of debt inflows (which have risen substantially in recent years) to interest rates, no central banker will risk going down as one who ran the nation’s currency to the ground. So, the RBI is often using the interest rate to manage the currency (without saying so, as that would destabilise markets), even if the domestic economy needs the opposite prescription. The best solution is to devise capital controls to contain volatility, to which Rajan seems unreasonably opposed.
Alok Sheel, earlier in the PM’s economic advisory council, has suggested that the RBI could subtly target a stable ‘real effective exchange rate’ over time, allowing it to float within a band in the short term. But whether this can actually work in real time, given the power of the markets to manipulate the nominal exchange rate, is a concern – which brings us back to the importance of capital controls. The other issue on which there is a resounding silence is: What if lower interest rates create asset bubbles in stock and real estate, as in the US? Rajan, who predicted the 2008 financial crisis, has said little on this.
Senior Deputy Editor