Earlier this month I participated in an international conference - Macro and Growth Policies in the Wake of the Crisis - at the International Monetary Fund, or IMF, headquarters in Washington. It was organised by Olivier Blanchard, the institution's Chief Economist and Head of Research Department, along with three other leading economists, Michael Spence, Joseph Stiglitz and Paul Romer. Stiglitz is well known for his sharp criticism of the policies of the IMF in earlier crises.
The goal of the conference was to assemble a range of opinion on key issues facing the global economy. The conference examined what the crisis had meant for the theory and practice of monetary policy in the advanced and emerging markets. Blanchard felt the crisis had revealed significant shortcomings in the existing strategy to fight inflation. Otmar Issing, former Chief Economist of the European Central Bank, argued that the problem was not with the theory of inflation targeting, but rather with its implementation and application.
There seems to be some intellectual disorder at the highest levels of the global economic policy establishment on monetary policy and inflation. Then, how should we assess the Reserve Bank's monetary policy actions of March 17, when it raised both the repo and reverse repo rates by 25 basis points to 6.75 per cent and 5.75 per cent, respectively?
- The RBI has done right to initiate and continue tightening
- Tightening should end when the medium-term real interest rate is consistent with the cyclical position of the economy
- The RBI has to take a view on domestic growth, domestic infl ation and the global economy within a year
- The RBI should plan on nominal GDP growth of 14-15% in this fi nancials year, with real growth of 8.5-9%
- A policy pause at this time is expected and will be welcome
Let me start with risk management. It is now clear that the impact on India of the global crisis of 2008/09 was initially severe but was quickly contained. This outcome was not preordained, and was the result of sound policy, combined with a certain amount of luck. The policy actions were both monetary and fiscal, and had two important purposes: using government consumption to compensate for a slump in private investment, and flooding the markets with liquidity to deal with the sudden interruption of overseas finance, reversing the cycle of tightening that had continued until July that year. These outcomes occurred because the government was nimble and had guts, also because the Central government and the RBI had created the required "policy space" to loosen policy.
This is most obvious in the case of RBI, because of the aggressive tightening under Governor Reddy, but the same was also true for fiscal policy, although the fiscal consolidation of the Chidambaram years was less than ideal. This successful implementation of counter-cyclical macro policy in India took place - and in the middle of an uncertain general election - without the support of swap lines from the Federal Reserve in US that other Asian economies needed.
Partially influenced by the debt crises that erupted in Europe in late 2009, and under the guidance of the 13th Finance Commission, the government wanted to begin fiscal consolidation in last year's budget. Concurrently, the RBI initiated tightening steps with a series of moves. The RBI's key shortterm rate, its repo rate, has risen from 4.75 per cent to 6.75 per cent between January 2010 and its most recent move this month.
Seen from the perspective of policy space and flexibility, the RBI has been right to initiate and continue tightening. The question now is where and when this cycle should end. The qualitative answer is easy: it should end tightening when its internal forecasts suggest that the medium-term real interest rate is consistent with the cyclical position of the economy, taking into account the fact that monetary policy acts with a lag of 12 months.
This is easy to say, but hard to do, since it requires the RBI to take a view on domestic growth, domestic inflation and the global economy at least within a year. Of these, inflation due to events occurring outside the country is the most difficult call, given the uncertainty surrounding oil and other commodity prices. A second uncertainty is the domestic political, regulatory and investment climate, and its influence on domestic investment. A third judgment call is the outlook for capital inflows, given our balance of payments financing needs and the recovery in sentiment in the advanced countries.
In my view, the RBI should plan on nominal GDP growth of 14-15 per cent with real growth of 8.5-9 per cent. Current monetary policy seems to be neutral for these levels, as measured by real rates offered to depositors. Given the uncertainties in the global economy, the RBI needs to preserve policy space on both the upside and the downside. Despite the hawkish tone of its recent circular, I would expect, and welcome, a policy pause at this time.The author is a former Director General of the National Council of Applied Economic Research.