Baby steps are pleasing to see, but when it comes to policy-making, one has to see where they go. Policy statements rarely provide the specific rationale for the proposed “baby steps”. Economists, who see “baby steps” as “interest rate smoothening”, infer a rationale for such actions in a variety of ways, as for example from the minutes of the policy meetings where they are made available. These “baby steps” are said to reduce financial market volatility. Central banks often believe that their credibility would be more secure if “baby steps” are taken in view of the many uncertainties relating to data, parameters and global economic conditions. All policy papers refer to such uncertainties.
The rationale for “baby steps”, if any, is often times overshadowed by the plethora of data that central banks give in the policy communications. While data dissemination is important, what is critical is analysis of data along with explanations of key relationships that would be generally valid in the short- and medium-term periods, especially when the sustainability of the current phase in the economic cycles is not firmly established. Data analysis is necessary for ensuring that the perception of economic participants is in line with their expectations of how the economic variables would move in the short to medium term. Instead, many central banks practise the art of creative linguistic sophistication partly because of the indefiniteness about the lags in impact of policies.
The Indian case is situated in a unique position at this point in time. The Reserve Bank of India (RBI) exerts its independence in announcing policy rate changes whenever it feels that economic situations warrant them and not necessarily at the conclusion of the scheduled policy meetings. RBI also does not publish minutes of the meetings. This makes it all the more difficult to know what exactly is the impact of the “baby steps” in policy-making at each point in time over the short-term and medium-term of three years.
Economic realities are more important than mere statistical numbers. Commodity inflation, especially of food articles and fuel products, is what counts for most households. Forget about the wholesale prices with the old or the new base periods. What is critical for the householders are the retail prices that often represent a hefty mark up over the wholesale prices, depending on the special circumstances or the region under view. If one were to be in the Northeast, the retail prices that one pays would be higher than what consumers in other regions pay for the same commodity. Much depends on how food and fuel inflation would evolve in the remaining months of the year for retail prices or for that matter wholesale prices to be within the range of 5-7 per cent. One factor that would influence the outcome would be the food output growth and the international prices of crude oil. The overall growth is placed at about 8.5 per cent in 2010-11. But National Accounts information seems to suggest that consumption demand has not picked up.
Bank deposit growth has been sluggish and so is the credit growth, with expectations of a pick-up in credit in the coming months. The not-much focused non-bank financing, however, has been significantly high. Asset markets — in particular real estate and housing and stocks, and to some extent consumer durables, including gold — have been expanding both in terms of size and prices. The prices of real estate and gold as well as of stocks have soared so high that low-to-middle-income earners find it difficult to work out plans of having a stream of future incomes that would protect them from erosion of their real incomes. Asset growth has, in fact, been fuelled by a number of factors. Capital inflows and strong growth over a number of years in incomes with bonuses and other perquisites to white-collared workforce in the private sector are only two of the factors. In order to protect the real incomes of the public sector employees, the government granted increases in their emoluments, thereby aggravating the aggregate demand. The sharp increase in demand against the reduced availability of food articles in the preceding financial year, and in the period till now of the current year, led to not merely further commodity price increases but also to inflation expectations.
How do the householders react to the erosion of real incomes? Will they be satisfied with the authorities’ attempts to improve supplies through fiscal incentives and to control aggregate demand through hiking interest rates in “baby steps”? The measures taken so far have not shown pronounced effects probably because of lags. As Keynes reminded us, the patience of the public is very limited. Private households and other agents tended to control consumption expenditures and invest in assets that give them high financial returns. The strong demand for assets is thus not a mere reflection of excess liquidity but a clear need to safeguard the real incomes in the wake of high inflation expectations. The large demand for assets would, however, not be possible without borrowings supplementing the own savings of households. The large foreign capital inflows (especially of the portfolio variety) have exasperated the situation.
To the extent private demand for assets is financed by banks, the central bank could tighten its regulatory framework with the help of improved monitoring mechanisms and sophisticated supervisory techniques. But where the private demand is financed by non-bank sources and unorganised sources in a significant measure, questions about financial stability would arise.
If there is merit in the above analysis, one wonders whether the current focus on “baby steps” only with reference to economy overheating is too narrow. There is very little indication of official appreciation of the challenges that would be posed if confidence in the sustainability of asset market growth is eroded and asset market volatility becomes a problem. There are very few good research studies that help one understand the factors that trigger asset market growth on such a sustained basis as at present and on the relationship between asset markets and commodity markets. Apparently, non-bank financing is not yet considered to be significant in the overall financing of activities. There also seems to be some complacency over the fact that the proposed Basel-III norms do not pose a problem for Indian banks.
It is time that the discussion on monetary policy is centred not merely on interest rate changes but also on the character and composition of financial flows. It is important to consider whether the “baby steps” and the structural measures that monetary policy takes would be able to address the problems that sharp asset markets growth and volatility generate in the short-to-medium term.
The author is former executive director, Reserve Bank of India