Monetary policy in a bind

CONDUCT OF MONETARY POLICY IN INDIA
Changing Dimensions in the Post-Reform Period
Amaresh Samantaraya
T R Publications; Rs 895

This book, as the blurb says, is an attempt to review the process of evolution of the monetary policy framework from a highly administered regime of credit and interest rate regulation to the present move towards the adoption of "inflation targeting".

The description and the discussion of the trends in policy have been done well, both in terms of facts and interpretation. I have, however, a few critical comments that do not in any way detract from the author's valuable contribution.

The author concludes that monetary policy in India presents a successful story of achieving high growth rates with largely stable prices over the last three decades. It is true that the country has broken out of the logjam of the Hindu growth rate of three to 3.5 per cent for nearly three decades since independence. But the price the country has paid in achieving higher growth rates needs to be recognised. The level of prices today is very high whether it relates to prices of commodities and services or assets - both physical and financial. India has become a high-cost economy.

The fault lies in the Reserve Bank of India (RBI)'s estimation of the desired money supply growth to meet demand. The latter is measured as the product of the expected percentage growth in gross domestic product (GDP) and the income elasticity of demand for money (IEDM) and adding five per cent to it to provide for a "tolerable inflation rate" of a similar magnitude. The estimation of demand for money is on the right lines, but the addition of five per cent to accommodate inflation is wrong. In reality, the targeting of inflation at five per cent makes it the minimum that the central bank assures the country! This target is based on two incorrect assumptions. One is that a little inflation is good for the country. Second, the formula was given by the Chakravarty committee on the working of the monetary system (1985) on the assumption of an additional four per cent on the supply side to provide for inflation. The questionable rationale was that it would reflect changes in relative prices necessary to attract resources to growth sectors. The four per cent became five per cent later and, now, it is six per cent! According to the Preamble of the RBI Act, its focus should be on "monetary stability". One would think that the phrase refers to the stability of prices, not the inflation rate.

According to my calculations, if money supply (M3) had increased by the rate warranted by the growth in GDP and a liberal estimate of IEDM at two from 1984-85, M3 should have been Rs 17,34,310 crore at the end of March 2009, instead of Rs 47,64,019 crore, following the panicky overreaction to the Lehman Brothers crisis*. The excess money supply accumulated over a quarter century was Rs 30 lakh crore! No wonder, the price of an apartment in Mumbai valued at Rs 3 lakh in 1984-85 went up to Rs 1.5 crore, at one end of the consumer spectrum, and that of a single capsicum from 20 paise to Rs 20, at the other end - examples of hyperinflation at selected individual commodity levels.

The liquidity adjustment facility has often worked with the repo operations taking the form of refinance due to continuous rollover of the repos over a long period. There have been instances of banks with surplus statutory liquidity ratio securities utilising repo funds for further lending in the call money market.

The author has referred to the termination of the arrangement of automatic monetisation of the fiscal deficit through the issue of ad hoc treasury bills to the RBI. But he is silent on the central bank's debt buyback operations before the government floats a new securities issue. The buyback pumps liquidity into the market, enabling the government to raise resources at lower cost, which amounts to financing the fiscal deficit by the back door.

The approach to inflation was faulty on two counts for a long time, which has undergone corrections recently due to constant criticism. In the first place, instead of the Consumer Price Index (CPI), the Wholesale Price Index (WPI) was taken to be the basis for judging inflation rates. Secondly, the central bank adopted the Western concept of "core inflation" that excluded food and fuel prices in its assessment of inflation rates and the formulation of policies.

The RBI is in a policy bind, having exhausted the instruments in its arsenal. The latest RBI policy review announced on April 7, 2015, is strong in expressing anti-inflationary sentiment and is clear in emphasising the importance of headline inflation measured by the CPI inflation. But the reconciliation of growth with price stability calls for greater coordination between the central bank and the government. How can the interest rate policy alone tackle the problem when what is required is supply management?

*"Curtain Raiser for Monetary Policy of RBI - Too much money supply" (Business Line, April 14, 2010)