How ‘dark matter’ influences inflation


With the Government naming the new Reserve Bank of India (RBI) Governor, there is a lot of interest in what it means for monetary policy and specifically interest rates going forward. Will it mean continuity or a departure from the path charted by Dr. Raghuram Rajan? What should the Governor focus on both in the short-run and in the long-run?

Even before taking office, I believe Dr. Urjit Patel has won half the battle in making a successful transition. For this, I congratulate mostly the Government. Let me explain.

Ignorance, inflation

While a lot of ink is spent on talking about the factors that affect inflation such as oil prices, monsoon, Government spending, global demand and interest rates, often missing in these discussions is how much we don’t know about what determines inflation.

I want to call this ignorance, “dark matter” or “expectations about the future”. Inflation is an aggregation of individual prices for goods and services. When traders set these prices, they do so based on their expectations about the future demand and supply conditions, including that for money. Where do these expectations come from? Nobody knows. Even in developed countries, where regulators are supposed to know more about how the economy works, central bankers are currently fighting a losing battle with inflation. In India, Dr. Rajan developed a reputation for being a hawk with regard to inflation. I cannot but believe that such a reputation played a role in affecting people’s expectations. Now that Dr. Patel is viewed as someone cast in the same mould, the foot that the RBI has on the throat of high inflationary expectation is not going to relent and this is half the battle won.

The next arena where Dr. Patel’s performance will be judged is the foreign exchange market. That market is facing the prospect of both an imminent increase in U.S. interest rates and the redemption of about $20 billion of FCNR deposits. In this area, the best the RBI can do is have a war chest and be willing to use it to tamp down volatility. The outgoing Governor (and Dr. Patel) have talked about the ripple effects of a Fed rate increase on emerging markets. Unfortunately, there is nothing else they can do. India is too small a trading partner for the U.S., to take the externality into account in setting interest rates. Given how anticipated these events are, I believe that the RBI has plans in place to deal with any possible volatility in the currency market. The third area that has attracted the attention of both monetary authorities and commentators is the speed of monetary transmission. There is widespread criticism that the banks are not passing on the rate cuts to the borrowers. The question is what to do about this. Here, not only do I disagree with what the RBI has done, but I also strongly believe that the RBI has worsened the situation.

In its efforts to speed up the transmission of monetary policy, the RBI has pursued an aggressive policy of prescribing how banks should determine their prime lending rates. Banks have been told to rely on their marginal – instead of average – cost of funds to set their lending rates. This is a misguided intervention and is taking the country backward in its march towards a market-based economy. The regulator – whose primary responsibility is to manage the risk in the banking system – should not have any role in specifying how banks set their lending rate. That should be left to the discretion of self-interested banks. If Adam Smith’s invisible hand is not let to do its work here, I am hard pressed to think where else it will be given a free rein!

Poor timing

Second, through the arbitrarily imposed deadline of April 2017 for banks to clean up their balance sheets, the RBI has worsened banks’ ability to pass on the lower interest rates to the borrowers. While no one argues with the need for banks to clean up their balance sheets, one can definitely quibble about the timing. Ideally, cleaning up of bank balance sheets should coincide with rising asset prices and equity infusion from the main shareholder, in this case the Government. This will enable banks to continue lending even when making large provisions. At the height of the financial crisis in the U.S., the federal reserve allowed banks a moratorium on marking some of their distressed assets to market because of the recognition that it would result in the banks booking significant losses, which in turn would erode their equity and their ability to lend to aid recovery. The RBI’s deadline of April 2017 for banks to clean up their balance sheets is arbitrary. Monetary transmission will be impeded if banks are forced to record NPAs without equity infusion from the Government.

For those interested in research in finance and economics, India offers an attractive laboratory because Indian regulators are among the most active. They keep tinkering with the rules constantly and this affords a number of “natural experiments” for researchers. At the cost of hurting myself, I think what India needs are humble regulators who realise that the economy is over-regulated, command-and-control is not the way forward and that it is imperative to do less and stay in the background.