Economics is not a science. It is an art. Economic policy is shaped as much by statistical evidence and models as by an appreciation of human psychology and social behaviour.
This commonplace observation has to be repeated once again in the light of the debate that preceded and followed the last week’s monetary policy statement of the Reserve Bank of India (RBI). Several economists, bankers, financiers, market analysts, investment managers and advisors, and many in the media, got all worked up about whether or not the RBI should raise key policy rates by 50 basis points (bps) rather than 25 bps. Voices recommending no increase at all were few and far between.
Even those who felt inflation was not such a big problem anymore, or that it had peaked and was showing a downward trend, or have been worried about the growth-dampening effects of an interest rate increase went along with the consensus view, including the media, that there would be a 25 bps increase, which was par for the course.
Even the redoubtable Deepak Parekh, who told a business daily on the eve of the RBI’s policy statement that “inflation is high”, expected the central bank to go in for only a 25 bps hike and explicitly ruled out a 50 bps hike. When this newspaper called for a 50 bps hike, wise economists chided me for offering such nonsensical advice! What the advocates of “baby steps” missed was that by “discounting” a 25 bps hike the market may well have forced the RBI’s hand into opting for a 50 bps hike.
Why do I say this? If the consensus view had been against a rate increase, even a 25 bps hike would have sent the message that the RBI was trying to give. But if markets had already discounted a 25 bps hike, the only way the RBI could have sent the message was by going for a higher-than-expected increase. The central bank’s basic objective last week was to alter the state of expectations; get markets and policy makers to focus on decelerating growth; and get a grip on fiscal policy and rein in inflationary expectations.
John Maynard Keynes told us long ago that investment and growth were shaped less by interest rates and more by “animal spirits” and the state of expectations. Economic policy in a market economy is not so much about setting rates and adjusting growth targets; it is essentially about shaping and altering the state of expectations.
In the Indian interest rate vs growth theology, one of the famous parables used to draw the moral that rate increases hurt growth is the infamous 1997 episode. Growth was hurt after 1997, say the anti-rate-hike-wallahs, because the unalloyed monetarist central bank governor of the time, C Rangarajan, increased rates. There is, however, an alternative hypothesis that many have since offered. Could it be that growth decelerated after 1997 for a variety of reasons that combined to turn expectations bearish, after the bullish 1992-97 phase? The uncertainties were created by the coalition politics of the day (Deve Gowda and Gujral governments from 1996 to 1998), the Asian financial crisis, the fiscal battering inflicted by the Fifth Pay Commission report, the economic consequences of Pokhran-II nuclear tests and post-test economic sanctions, and so on.
When so many factors were generating negative expectations about growth prospects, dampening the “animal spirits” of entrepreneurs and curbing the government’s ability to spend and implement pro-growth policies, how could a mere easing of interest rates have prevented a slowing down of the economy? Interest rates cannot be the tail that wags the dog.
It can be easily argued that the increase in interest rates in 1997, as in 2011, was meant to alter the state of expectations and help make growth more sustainable. Clearly, the central bank opted for a 50 bps hike, rather than delivering on market expectations, to signal the arrival of what this paper’s columnist Abheek Barua has dubbed the “new normal” in India — not just a higher expected rate of inflation but a lower potential growth rate. The growth-inflation ratio of 9:5 in Union Budget 2011 has been altered to 8:6.
Even if New Delhi was not party to the move, the speed with which Union Finance Minister Pranab Mukherjee, PM’s Economic Advisory Council Chairman C Rangarajan and Planning Commission Deputy Chairman Montek Singh Ahluwalia issued statements agreeing with RBI Governor Subbarao suggests there was far greater convergence of thinking between Mumbai and New Delhi than one might imagine. All of a sudden, there has been a paradigm shift. Inflation is no longer viewed by India’s macroeconomic authorities as the “price of growth”. It is seen as a barrier to accelerated growth.
In altering market expectations about growth, India’s policy makers are also drawing attention to the multiplicity of factors – economic, political, administrative, social, strategic and global – that may be working to reduce the expected rate of growth in the near term. However, policy makers can help restore economic momentum and revive sagging “animal spirits” of entrepreneurs.
After the results of the state assembly elections are announced this week, and following the 20th anniversary of the “new turn” in economic policy of 1991, a series of policy initiatives can help revive sentiment and impart new momentum to growth. With the assurance of greater political stability after the elections, more purposive governance and steps to ensure fiscal sustainability of growth, a more confident government revitalised by new talent and a new agenda can revive positive expectations and, subsequently, boost growth. Generating positive expectations is the key governance challenge today.