The Hindu Business Line : Asset prices must guide monetary policy

If, when and how the RBI should tamper with the interest rates seems to be the second most discussed subject in business circles these days, after the public spat between the Ambani brothers. Most of the arguments, both for and against interest rate cuts, are fundamentally based on the inflation hypothesis (that is the level of inflation relative to its target). But inflation has time and again proved to be an insufficient indicator; especially given the way we measure it (CPI and WPI).

One thing that we have learnt, if at all, from the recent global financial crisis, is that, purely focusing on goods and services inflation does not work well in the context of setting interest rates. What we need is a new model, a more holistic approach to monetary policy that takes into account ‘asset prices’ and the resulting imbalances.

Before the latest crisis, many economists believed in the Greenspan school of thought which professed that the cost of allowing a bubble in the financial or real estate markets to run its course was relatively small. Hence it was assumed that it would be sufficient to focus on inflation indicators.

The argument was that interest rates could always be cut ex-post to contain the damage resulting from the bursting of a bubble. As we all now know, it was the abnormally low interest rates in the beginning of the decade in the US (due to massive cut in rates after the dotcom bubble burst) that was the primary cause of a much larger bubble in housing, the bursting of which has caused the latest set of problems.

In hindsight, interest rates in the US should have been significantly higher in the 2001-2004 period. Recovery from dotcom bust would have been slower. Inflation would have been much lower than the target. But the asset price bubble could have been prevented.

Still, the default position of policymakers seems to be that interest rates should not be used to stifle a boom in financial markets. It is felt that the cost of leaning against imbalances in financial markets is high. This is because (a) economists would find it difficult to differentiate between movements in asset prices that could be justified by fundamentals and those that reflected bubbles; (b) acting under wrong circumstances may cause more problems than what one aims to solve.

No doubt, setting monetary policy in line with developments in financial markets is a challenging task. But it is one that economists should embrace, rather than shy away from — at least for the sake of preventing the next mega bubble.

Measuring inflation

Another fundamental question is whether the inflation-targeting regime itself needs to be overhauled. On the one hand there seems to be a never-ending dispute about which consumption items (goods and services) must be considered for measuring inflation.

On the other hand, setting a target for price inflation using a measure that excludes the costs of primary ‘assets’ such as real estate (home ownership) is not favourable from a policy context.

India has five price indices – one wholesale price index (WPI) and four consumer price indices (CPI). There are consumer price indices for rural labour, agricultural labour, industrial workers and urban non-manual workers. The last one – the urban CPI, has been discontinued from direct computation in 2008. In its place we have an indirect ‘link’ index, which takes the group level index values (like food, beverages and tobacco, fuel and light, housing, etc.) that are collected for computing the industrial workers CPI and a different weightage ratio is applied to them.

The issues regarding relevance of WPI as the key indicator for inflation are well known. In fact, much of the world has stopped using WPI and has switched to CPI. In our case that is easier said than done, because we would not know which CPI to pick – among the four options available!

Single inflation index

Of course the recent developments initiated by the Finance Ministry to merge the CPIs into a single index may hold the key to the solution. But, even if we achieve the merger of CPIs, we will continue to face the problem of how ‘Housing Index’ – one of the key components within the CPI is being calculated.

Currently we compile housing index, using the actual rent paid (in case of rented houses) or equivalent rent paid (in case of self-owned houses). The Case-Shiller studies have clearly demonstrated that rentals do not mirror the Home Price Index.

Using rentals in CPI could technically cause the CPI to remain flat when real estate price is skyrocketing and hence skew the whole picture. This skew is one of the main reasons for a misleadingly low inflation in the US, during the first half of this decade – leading to the false belief that low interest rates were sustainable.

By the time the Fed started inching up the rates, the housing bubble was too big. Let us not make the same mistakes that the US did. Given the various flaws associated with how we currently measure inflation, it is by no means a robust measure for setting monetary policy.

The state of financial markets and their impact on asset prices will provide a more effective framework for pro-active decision-making. Such an approach would prevent imbalances from building up, by taking action at an early stage.

It is about time our central bank looks beyond inflation and starts worrying about the way in which Asian stocks and real estate prices have rebound and continue to rise. We may not be able to afford another bubble in such a short span.

(The writer is a Senior Consultant with ECS Pvt. Ltd. – a subsidiary of PricewaterhouseCoopers.)

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