Thursday, August 5, 2010

Of Governors and “Senior Officials”…

Over the last few days, apart from the regular newspaper columns and opinions, many readers have emailed saying the RBI is either confused about what its doing, or is acting under political influence. This feeling was compounded when an unnamed “senior official” , in comments soon after the recent policy announcement said that the current inflationary environment needed “aggressive policy action” and current policy wouldn’t tame inflation.

I agree with the official partly. Current monetary policy will not tame inflation, but that’s where my agreement with the unnamed official ends. It won’t do so, not because more needs to be done, but because current inflation has less to do with monetary policy and more with supply side shocks and international market movements. Inflation will reduce, but purely due to statistical reasons I have outlined earlier. Also, if any form of monetary policy can have a meaningful impact on current inflation, it will have to be the exchange rate policy and not the interest rate policy. Granted that there are signs of inflation getting broad-based, but isn’t that expected after a sharp increase in fuel costs. After all, transportation is an significant part of final cost in virtually every product today.

Though comments of this nature confuse the market and observers about RBI’s real thoughts, this isn’t a new phenomenon. Dr. Y.V. Reddy, when he was Dy. Governor, frequently & publicly disagreed with his Governor, Dr. Bimal Jalan. And it was always caused by his angst of Dr. Jalan’s refusal to combat everything through interest rate hikes.

In reality, the formative years for most of the RBI’s middle & top brass were simpler times. Times when the exchange rate was decided by the RBI and obeyed by the market. Times when the possibility of attracting capital flows in excess of our requirements was unimaginable. Times when inflation was largely a domestic phenomenon (remember oil prices remained stable for a long long time before going through the roof only in the 21st century, and when they did spike we had ourselves a crisis) and India was still a nation where individuals could only save, and not borrow. Times when the government did not have to borrow from the market to fund it’s deficit and wasn’t affected by interest rate changes significantly.

In these times when inflation rose, interest rates were hiked regardless of what constituted inflation. And it wasn’t because  that was the right thing to do. It was the only thing they could do. As an added benefit, the purchasing power of savings was protected, at least partly, due to such higher rates which imparted moral underpinning to actions devoid of any other kind. To a large section of these people, every step of the liberalization process has been accompanied by a growing feeling of inadequacy, driven by their inability to deal with the consequences. Consequences like excessive capital flows and their impact on the exchange rate, like domestic prices which are increasingly connected to global prices and the fact that inflation can now exist without any domestic reason whatsoever.

Faced by their own inadequacy, and the lack of an incentive to change with the times, their thoughts turned into dogmatic beliefs that need to be defended with quasi-religious zeal. They oppose and object to anything that reduces the power they had over markets, like capital flows and flexible exchange rates. But more than anything else, they object when the only policy instrument they are familiar with is not used to impose sacrifice and austerity on an increasingly indulgent population.

A minority, however, chose to adapt. Excited by liberalization and the opportunities it offered, they updated their knowledge and enhanced their skills. It is this minority that stood by Dr. Jalan in his efforts to forge a new path for Indian monetary policy. One that was characterized by transparency and an open minded analysis of the suitability of traditional policies, parameters and goal posts. It was at this time when the foundation for India’s best economic years was cast. Monetary policy then was an eclectic mix of the traditional and the unconventional. But it wasn’t always so. In his initial years as governor, Dr. Jalan was fairly tentative in his attempts to break the mold. He spent the first couple of years identifying and manning  key positions with the right people. It was in his third year as governor, in 2000 when he eventually succeeded, aided by the team he had painstakingly built.

But this divide doesn’t exist just within the RBI. Outside as well, we see a clear divide between those who look at headline inflation and demand hikes and those who analyze the components and request patience, realizing that there is nothing, absolutely nothing to be gained by hiking rates in the current environment. This divide existed during Dr. Jalan’s time and exists now.

Dr. Subbarao is charting a course similar to Dr. Jalan’s. In his latest monetary policy statement are signs of a new found independence in thought and a self assurance which was missing in earlier policy statements. And while current inflation still doesn’t demand the sharp interest rate increases he has imposed, neither rates nor liquidity are, at the moment, serious threats to growth. The 10 year GOI benchmark yield has remained stable moving from 7.89% on March 19, 2010 just before the rate hikes began to, well, 7.89% on August 3, 2010. Hardly a sign of bond market distress. While there are those who will see this as a worrying sign of inefficient monetary policy transmission and still others who would claim this to be a sure sign that RBI is behind-the-curve, I would contend that it reflects an increased certainty regarding the conduct of monetary policy which has compensated, at least in part, for higher overnight rates. The hands off approach to exchange rate volatility is another example of change. In refusing to control the exchange rate market on a day to day basis and increasing the range of tolerable movement, both positive & negative, Dr. Subbarao has relieved the RBI and the Indian debt market of a great burden. This preference towards domestic stability at the cost of exchange rate volatility is welcome, more so when compared to Dr. Reddy’s time when fixation with exchange rate stability caused unprecedented volatility in domestic overnight rates. The worst episode, in March 2007 saw interbank call rates move between 2.50% and 75% within the month (Source: RBI)

While I have, and continue to, oppose rate hikes, I sense light at the end of the tunnel. This isn’t a governor who is confused or tentative. This is a governor finding his feet and preparing to make a difference, allowing his detractors small victories that don’t cause much harm; gaining strength with each passing month.

I take the comments of the anonymous senior official as a sign that interest rate hawks are playing a smaller role in policy making. So now, all they can do is speak.

A version of this post appeared on my Business Standard Blog on August 4, 2010

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