Will Raghuram Rajan's monetary policy yield fruit in new fiscal?
Is it possible to target inflation with monetary measures of the Reserve Bank of India, is a question raised recently by the International Monetary Fund in its working paper - Monetary Transmission in Developing Countries; Evidence from India - brought out this month.
The highlights of the paper are summarised here for the benefit of the readers.
The effectiveness of monetary policy in influencing aggregate demand varies with circumstances.
As is well understood, the channels through which monetary policy affects aggregate demand depend on a country's financial structure.
Relevant factors include the extent of the country's links with external financial markets, its exchange rate regime, the size and composition of its formal financial sector, the degree of development of its money, bond, and stock markets, the liquidity of its markets for real assets such as housing, and both the costs to its banks of doing business as well as the competitive environment in its banking sector.
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| RBI governor Raghuram Rajan leaves office next month. |
These issues are quite relevant for India.
Despite its size and relative economic success over the past two decades, India remains a lower middle-income country (by the World Bank's classification) with an institutional environment and domestic financial system not dissimilar from that of many countries at comparable income levels.
Moreover, the RBI recently implemented an inflation-targeting regime that requires it to hit publicly announced inflation targets.
Effective monetary transmission is potentially crucial to the success of this regime.
In the absence of effective and reliable links between the policy instruments controlled by the RBI and aggregate demand in the Indian economy, the public may lack confidence that the RBI is able to deliver on its announced inflation target, making the target more difficult (and costly) to achieve.
The effectiveness of monetary transmission in any country depends on a variety of characteristics of its economy.
These are usefully classified into macroeconomic and microeconomic factors.
Macroeconomic factors include the economy's degree of integration with external financial markets as well as its exchange rate regime, and microeconomic factors refer specifically to the structure of its financial system.
A complicating factor in this regard is that the evolution of monetary policy in India has historically been characterised by the use of multiple instruments.
Two broad groups of instruments have been used to conduct monetary policy: (i) price-based instruments that affect the cost of funds for banks, in the form of the repo rate and the reverse repo rate, and (ii) quantity-based instruments, which directly affect the volume of lending by banks, in the form of the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR).
Alternative measures of stance of monetary policy
There are three alternative measures of the overall stance of monetary policy. First, we extract the first principal component from the repo and reverse repo rates, as well as the CRR and SLR.
The first principal component explains about 50 per cent of the total variance in the four variables; and mirrors closely the evolution of the first principal component based only on the repo and reverse repo rates, reflecting the strong co-movement in these rates caused by the "corridor" approach and the use of the quantity instruments as complements to the price instruments.
The IMF working paper assumes significance in the wake of the government's appointment of the Monetary Policy Committee to target inflation and rein in price stability by helping to keep the retail inflation based on CPI, which almost touched 6.1 per cent by end-July.
In the absence of an effective and reliable link between the policy instruments of the RBI and aggregate demand in the Indian economy, it is not clear whether the RBI can deliver on its announced inflation target of 4 per cent plus or minus 2 per cent points over the next five years.
It can make it more difficult and costly to achieve the target by the RBI, says the working paper.
Careful studies in low-income countries have often found monetary policy effects to be counter intuitive, weak or unreliable.
On the other hand, it says the small size of the formal financial sector in India may undermine the effectiveness of bank lending rate charges on aggregate demand.
However, Moody's is of the opinion that credibility and effectiveness of monetary policy are factors which impact India's sovereign ratings. Moody's has a "Baa 3" rating on India with a positive outlook.
Similar policies of the RBI and communications to achieve such targets will demonstrate its commitment to keep a tight leash on inflation.
Inflation in the past had risen to very high levels, negatively affecting growth and investments.
RBI governor Raghuram Rajan, who demits office next month, though accused of holding rates, had stuck to his stand and asked critics to show how " inflation is very low" before accusing him of "being behind the curve".
Retail inflation or CPI has risen to an all-time high of 6.1 per cent in the last 23 months and the world-over experience of initial tendencies of GST (Goods and Services Tax) is to push up inflation.
However, inflation-targeted monetary policy is the only hope for enhancing transparency.
It is believed that the present RBI strategy will suit India's specific economic and institutional structures though the evidences of the working paper of the IMF show the results to be somewhat otherwise.
Let us wait and see how the seeds of monetary policy sown by Rajan sprout and what kind of a harvest they bear at the end of kharif 2016.