The Reserve Bank of India (RBI) is in the eye of a storm once again. The decision of the monetary policy committee (MPC) headed by RBI governor Urjit Patel to not lower policy rates in its meeting last week attracted sharp criticism from North Block, with chief economic advisor to the finance ministry, Arvind Subramanian, questioned the wisdom of the move.
Disagreements among India’s top policymakers over the appropriate interest rate are neither new nor entirely unexpected. Given its mandate to target inflation, a central bank is prone to being hawkish about interest rates. Governments, especially in countries such as India with high fiscal dominance, typically prefer lower rates because they tend to be the largest borrowers. When uncertainty over growth rises, such differences can become sharper, as seems to be the case now.
At such times, it is useful to consider what an apolitical policy rule such as the Taylor rule suggests about the appropriate interest rates for the economy. This yardstick, developed by Stanford University monetary economist John B. Taylor, estimates the desired level of interest rates based on two parameters: the output gap, or the difference between actual output and potential output; and the inflation gap, or the difference between actual and targeted rate of inflation.
As the chart shows, the Taylor rule suggests that Arvind Subramanian is right to call for interest rate cuts.
Obviously, setting interest rates is a complex issue and it would be naïve to assume that any one rule can authoritatively settle the debate over what a central bank should do. There is even dispute among economists over whether a rule is warranted at all, given that discretion in policy-making might be useful in providing desirable “shocks” or surprises to markets as and when required.
Nonetheless, a monetary policy rule can serve as a useful benchmark. The attractiveness of the Taylor rule comes from two reasons: it is a widely used benchmark globally; and Indian policymakers, including RBI officials, have often referred to it in the past.
As the chart shows, today the gap between RBI’s policy rate and the rate path prescribed by the Taylor rule is at its widest in nearly two years. This is not surprising given that consumer price (CPI) inflation has been below the 4% target for more than six months now.
Even though the wholesale price index (WPI) shows a higher inflation rate today compared to CPI, even a WPI-based Taylor rule suggests that interest rates may be higher than warranted.
Of course, it could be argued that as monetary policy operates with a lag, low inflation at present need not necessarily warrant an interest rate cut if inflation is forecast to rise. In fact, the forecast released by RBI in its latest monetary policy statement suggests that inflation might rise in the second half of 2017-18. However, the problem with this argument is that RBI’s recent inflation predictions have often been off the mark and that too consistently on one side—it has been repeatedly overestimating inflation. For example, in its December 2016 meeting, RBI said “headline inflation is projected at 5% in Q4 of 2016-17 with risks tilted to the upside”, while actual inflation in that quarter eventually averaged 3.6%.
The other big consideration for rate decisions apart from inflation and growth is exchange rate pressures. It is prudent for a central bank to maintain a hawkish stance when the currency faces depreciating pressure. But if at all the rupee faces any pressure today, it is one of appreciation rather than depreciation.
Given macro-economic trends, and the rising pressures from the finance ministry for a rate cut, it remains to be seen how long RBI will maintain status quo. The bond market seems to have made up its mind already, and has started pricing in the possibility of rate cuts over the new few months.