The Hindu Business Line : The central banker's puzzle

Different central bankers have their own national experience and policy objectives to go by in determining their anti-inflation stance. While maintaining a reasonable threshold for inflation levels, Governor Reddy has to keep in mind the need to increase both savings and investments in the economy, says S. VENKITARAMANAN.

It is said that central bankers are in the habit of removing the punch bowl just when the party gets going. Perhaps, they mean it well. Too much punch drives party-goers crazy. The warning is rightly directed towards curbing inflationary tendencies.

The RBI Governor, Dr Y.V. Reddy, played the classic role of the punch-bowl remover by raising interest rates ever so slightly, by 25 basis points (0.25 per cent) in respect of the two indicative rates — the reverse repo and the repo rates — last week. Given the mayhem in the market, Dr Reddy's actions did not have much direct impact as the rout had already begun, driven mainly by international factors. But Dr Reddy was conveying a message — that he was ready to strike when the iron was almost hot, snuffing out inflationary pressures.

What does the Governor's action imply? The reverse repo rate is the rate at which the RBI borrows from the market or absorbs liquidity from the banks. In fact, this is analogous to the Fed funds rate, which the US Federal Reserve determines from time to time. The rates have a clear signalling function. This rate sets the background for banks to determine their prime lending rate, deposit rate, and so on. In effect, the RBI has hiked the interest rates across the economy by 0.25 per cent.

The Finance Minister explained in an interview that he does not expect Governor Reddy to repeat the exercise in his July policy announcement. That may be stepping on the Governor's toes, for, after all, the RBI is jealous of its autonomy. But Finance Ministers are also zealous guardians of their turf which, they presume, includes telling the RBI when it gets off the track. No Governor of the RBI would dare cross the clearly expressed guidelines of the Finance Ministry in matters of interest rates and credit policy.

Historians of the RBI have written about the episode involving Governor Rama Rau and the then Finance Minister, T.T. Krishnamachari, when Governor Rau announced an interest change without informing the Finance Ministry. The dispute soured the relationship between the central bank and the Government so much that Governor Rau resigned.

Inflation-fighting?

That Dr Reddy was striking a blow for inflation-fighting is conceded by all observers. But, to the present writer, it does seem that he was trying to catch up with the global rate-curve rather than battling inflation. Inflation in India has so far been comparatively benign. It has hovered around 4 per cent, year on year, not counting the recent oil price increases (figures as of May 26). This must have increased slightly because of the pass-through of petro-price increases.

Overall, the inflation figure has been comparatively benign. Consider that inflation in 2006-07 has been at 4.3 per cent compared to 5.6 per cent in the previous 12 months. Its hold on the economy has loosened instead of tightening. Governor Reddy must have some more information on inflation prospects to justify his pre-emptive strike.

Perhaps, he was and is concerned that inflation is rearing its head globally. The spectre of inflation is appearing in developed nations, one after another. The Fed Chairman, Mr Ben Bernanke, has been looking ahead and worrying that inflation has been higher than expected. What, after all, has he been worrying about? Inflation, as per the Fed's preferred means, has been running at 3.2 per cent. Forecasts within the Fed show that the US economy may most probably slow down, bringing down the inflation figure. Why all this hullabaloo about an inflation figure that is not even earthshaking?!

Granted, central bankers are, by nature, cautious. Perhaps Mr Bernanke has reason to believe that the rising oil prices have still some potential to seep further into the economy. Also, he may be right in arguing that the "deflationary" effect that Chinese imports have had on the US market may be reaching the end of its potential as China too has limits on its capacity to produce and sell goods cheaper, given the higher costs of commodities, particularly crude oil.

Compared to Mr Bernanke, the head of ECB (European Central Bank), Mr Jean-Claude Trichet, had clearer vision. European Union inflation was accelerating to 2.5 per cent, up from 2.4 per cent in April/May — above the ECB's definition of price stability — a rate below, but close to, 2 per cent. It is no wonder that, with such a strict criterion on inflation, Mr Trichet chose to raise his interest rates last week, just before Governor Reddy did.

Japanese economy

Japan presents a discordant picture. It has been quite some time since Japan experienced inflation in the same measure as the rest of the world. The WPI consumer price index has risen 0.5 per cent in recent months. Stripped of energy costs, the residual rise is barely flickering. The gross domestic product deflator — a more precise measure of inflation — actually registered a slight fall of 1.4 per cent. The Japanese Finance Minister had rightly warned the central bank discreetly that a sudden rise of interest rates would not have a good impact on the Japanese economy.

The Bank of Japan has, however, abandoned its extremely accommodative monetary policy. It has recently been voicing the view that inflationary risks were present in greater measure than deflationary risks. This is notwithstanding Japan's comparatively good experience on inflation. Its inflation record from 1985 to 2005 was an average of 0.5 per cent against 3.2 per cent in the US and 2.9 per cent in the UK. Suffice it to say that Japan operates on a very different inflation threshold. The Bank of Japan's target for headline CPI — including food, energy and oil — is a figure of 0.2 per cent.

Different central bankers have their own national experiences and policy objectives to go by in determining their anti-inflation stance. While we may not be able to adopt the extreme standard of Japan, we have a more reasonable threshold of 4-5 per cent for inflation levels. Governor Reddy has, of course, to keep in mind the need to increase both savings and investments in the economy.

Keeping rates attractive

"Savings" mean a higher rate for savers. Higher investments require a lower and more benign borrowing rate. Also, Governor Reddy needs to keep in mind the danger of the asset bubble about which he has recently cautioned the nation many times.

Added to all this is the BoP consideration. Interest rates in India have to remain attractive enough to draw in funds from abroad. Besides, Governor Reddy cannot afford an erosion in portfolio flows. To what extent higher interest rates will impact portfolio flows depends on their impact on the stock market, which is difficult to identify.

Finally, there is the fiscal effect of higher interest rates. As long as the Government is a heavy borrower, higher interest rates translate into higher fiscal deficit, which may mean more borrowing and still higher interest rates, unless the Government raises taxes adequately. Here is the fiscal-monetary interface that Governor Reddy as well as the Finance Minister, Mr P. Chidambaram, are only too conscious of. Dr Reddy has fired the first shot. Will Mr Chidambaram be quick to follow with appropriate action on the fiscal front?

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