The Hindu Business Line : RBI’s Annual Report for 2008-09: Not the time for tight money

Money supply should not be squeezed in an economy hit by drought and high global commodity prices. A contractionary monetary policy could work against the fiscal stimulus introduced in the Budget, lowering growth to below 5 per cent, says S. VENKITARAMANAN.

The RBI’s concern is that an accommodative policy would worsen inflationary expectations.

The Reserve Bank of India’s Annual Report for 2008-09 has evoked some interest for possible hints on the future monetary policy stance of the central bank. It refers to the challenges before the central bank as a result of the increasing deficits of the Central Government.

The borrowing requirements of the Government amid the problems posed by a deficient monsoonand its effect on food prices have been looked into. The Annual Report points out that it is difficult to maintain the current accommodative stance of monetary policy in the light of continuing inflationary pressures, particularly in respect of food.The RBI’s concern is that an accommodative policy would lead to worsening of inflationary expectations. However, the Report does not necessarily hint at a reversal of policy.

CONTROLLING INFLATION

In spite of the wholesale price index (WPI) actually falling in the recent period, the price index for consumers (CPI) has been under stress, especially in respect of food. This trend is likely to worsen as a result of the faltering monsoon. Whether a tighter monetary policy — increasing interest rates and reducing liquidity — will lower inflationary pressures has been a subject of debate.

Some analysts have pointed out that monetary policy tightening cannot lead to increased supply responses and a fall in prices. Higher interest rates and reduced liquidity cannot obviously induce the farmer to produce more when the basic input, water, is diminished. Similarly, the RBI’s monetary policies cannot influence pass-through of international prices and the inflationary expectations generated by them.The indications in the Annual Report are that exit from the current accommodative policy is not on the cards. Milton Friedman famously said that inflation is always and everywhere a result of the increased money supply. Unfortunately, this ignores the fact that supply conditions, such as oil shocks and monsoon failure, may themselves cause price variations, even in the absence of money supply increases.

In fact, when demand contracts in an economy hit by drought, there will be a need for more money supply, by way of welfare and relief programmes .

Tightening of monetary policymay not, therefore, be appropriate in the context of the drought and the global rise in commodity prices. This would negatethe fiscal stimulus provided in the Union Budget. The net effect could well be of the economy limping back to sub-5 per cent growth.

In this context, it is worthwhile referring to the practice of the US Federal Reserve that is focuses on the core price index or the headline consumer price index, which reflects consumer price index increases, excluding food and fuel. Obviously, there must be some rationale for a central bank to concentrate on core prices, leaving out food and fuel price increases.

It would seem desirable for the RBI to examine whether its focus should also be on the core price indicator, viz, CPI, excluding food and fuel, for the purpose of monetary policy decisions.

While the CPI, as published, should as usual include food and fuel prices, the RBI’s policy-makers should set the interest rates and tighten liquidity based on core inflation indicators, excluding food and fuel.

MANAGING PROFITS

An interesting feature of the Annual Report, which goes beyond discussions on the economy, concerns the results of the working of the RBI itself.

As usual, the RBI has made substantial profits as a result of its investments of foreign currency assets in securities abroad. The total income of the RBI, both from foreign and domestic sources, during the period covered by the report is about Rs 61,000 crore.

This is basically made up of earnings from the investments of foreign currency assets and gold. The rate of return on investments on foreign currency assets during the above period was 4.24 per cent compared with 5.09 per cent in the previous year.

Suggestions that the RBI should consider investment of its foreign currency assets in a more profitable manner need to be closely examined. The recent experience of sovereign wealth funds, such as Singapore’s Temasek Holdings, which invested in the US stock market, does not lend support to such a suggestion.

Such funds burned their fingers badly by investing in stock markets in developed countries. The RBI’s conservative policy of investing in US Treasury securities seems to be the best option in the circumstances.

Of a total sum of Rs 61,000 crore earned by it, the RBI proposes to transfer Rs 25,000 crore to the Central Government. This is significantly higher than the previous year’s transfer of Rs 15,000 crore, from a net income of Rs 57,000 crore. The RBI has transferred large sums of money from its profits to the special funds created for the purpose, such as Contingency Reserves and Asset Development Reserves.

The practice of the central banks elsewhere does not support this procedure. The Federal Reserve transfers its entire net income to the US Treasury without transfer to any Reserve Fund.

The adoption of a similar practice could make a sizeable difference to the fiscal position of the Government. The relevant laws defining the terms of engagement between the Government and the RBI would have to be examined in this regard.

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