Should the Reserve Bank of India follow the Fed?

Arvind Subramanian 04 October 2008

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Roiling international markets, a declining currency, and stubbornly elevated inflation. These are fiendishly difficult and nerve-wrackingly uncertain circumstances for the Reserve Bank of India (RBI) to be making decisions about monetary policy. As liquidity has dried up, the Fed has maintained a loose monetary policy stance and the People’s Bank of China (PBOC) has also signalled a clear bias towards relaxing monetary policy by lowering its interest rate marginally. The obvious questions for the RBI are: should it follow the Fed? If not, why not?

At this juncture, the Reserve Bank of India, like the Fed, has two key objectives: bringing inflation down and maintaining confidence in the financial system in the wake of seismic events shaking world financial markets. The latter requires some combination of sustaining economic activity (or averting its collapse if one has a more dire prognosis) and maintaining the health of the financial sector to allow it to continue operating without distress.

Despite the common objectives and apparently similar circumstances, there are two reasons for the Reserve Bank of India not to follow the Fed. The first is the inflation outlook. Current inflation in both countries is well above policy-makers’ targets and comfort zones. But despite the relief that is on its way for both countries in the form of declining oil and commodity prices, the outlook for inflation is different for one important reason: the currency.

To the surprise of many, the dollar has remained relatively strong (until very recently) despite the US being at the epicentre of the financial crisis. In contrast, the rupee has depreciated sharply from 39 to the dollar to about 46. In terms of magnitudes, the exchange rate depreciation (about 20% affecting all imported goods) will probably outweigh the favourable food and oil price effects. Declines in oil prices will not have much impact on inflation because domestic prices are controlled and remain well below world prices (they will have an impact via the fiscal channel but over time). Food prices, which do have a more immediate impact on inflation, have not declined dramatically. On balance, inflationary pressures remain, and a cut in interest rates could stoke them by contributing to a further rupee depreciation. This would risk turning what has already been a marked decline into a disorderly rout, undermining confidence.

The second reason relates to confidence and the financial system. The seizing up of credit markets and evaporating liquidity that have gripped US financial markets could afflict India. Here the actions of the US Fed are instructive for the RBI. The actions of the Fed make clear that all objectives including inflation control are subordinate to that of preventing the financial system from collapsing and taking the real economy with it. If the Weimar hyperinflation is etched in the collective German psyche, the Great Depression is its American counterpart – the nightmare outcome that Ben Bernanke will flout every orthodoxy to prevent.

The Fed has tried to maintain confidence through two levers. First, through emergency liquidity provision. It has radically departed from precedent by enlarging the institutions that can avail themselves of the lender-of-last-resort facility, to encompass even those (investment banks) that had previously been beyond the purview of Fed regulation, and by widening the set of collateral against which liquidity could be provided.

The Fed’s second lever has been interest rate cuts, which have the well-known effect of sustaining aggregate demand and real activity, thereby averting a further collapse of confidence. But rate cuts have had another, less recognised, motivation. Keeping the financial system functional in these difficult times has required banks and others to acquire capital and strengthen their balance sheets, thereby sustaining their lending operations. Lower interest rates have been an important mechanism for the re-capitalisation of banks. How so?

Lower short-term interest rates achieved by the Fed typically go with higher long-run interest rates (the phenomenon of positively sloped yield curves). Banks borrow short and lend long. Ergo, low short rates widen bank spreads and increase their profits, providing valuable capital. The Fed’s rate cuts have been guided by the need to restore the profitability of the US financial sector.

What are the lessons for India? If it is indeed the case that the balance sheets of Indian financial institutions are respectable and not immediately threatened, then the case for lowering interest rates for reasons of sustaining the health/solvency of the financial system, is weakened. In other words, the problem in India, unlike in the US, is not, or at least not yet, one of solvency and inadequate capitalisation of the financial system.

In sum, there are two contrasts with the US. India cannot afford to lower interest rates because its currency movements, and hence its inflation outlook, are very different. At the same time, it does not need to lower rates to maintain the solvency of the financial system, which is mercifully healthier.

That said, liquidity conditions are tight in India, and there are worrying signals that the central bank needs to warily watch. The RBI should gear itself to be able to supply liquidity at quick notice should a need arise in the near future. One operational suggestion to improve this capability would be to re-centre the interest rate corridor so that the policy rate falls in the middle. Currently, the policy rate is at the upper end or above the corridor, which forces the RBI to keep the system chronically short of liquidity. This could become a potential problem should conditions turn worse.

Finally, a third, more general, reason also points to not relaxing monetary policy. Current decisions are being made under great uncertainty with substantial possibility of policy error. Tightening now could be a mistake if Indian markets are gripped by a loss of confidence. Equally, relaxing now could be a problem if past or future rupee depreciation entails elevated inflationary pressures and requires a switch back to tight policies. The key question then is which error is easier to rectify. The threat of a loss of confidence is still a potential one, and if it were to arise, could be relatively easy to address by flooding the system with liquidity. But this is less true of inflation control policies, which take longer to have effect.

This asymmetry favours maintaining a slightly tight bias to current policy. Central banking is a human art, involving difficult policy choices. To err may be unavoidable. To correct quickly is therefore essential.

Editors’ note: This first appeared in Business Standard on 26 September 2008.

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Topics:  Macroeconomic policy

Tags:  monetary policy, India

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