“Money is what money does”. This is one of the most profound, and yet rather enigmatic, statements in Economics. Raghuram Rajan, the RBI Governor, made a similar observation when, at the end of his presentation of the fourth bi-monthly monetary policy statement for the year 2015-16, he was asked if he has softened from a hawk to a dove. To drive home the point that he is neither a hawk nor a dove, he said, “My name is Raghuram Rajan. I do what I do”. (In Monetary Policy parlance, hawks focus exclusively on controlling inflation whereas doves try specially to promote more employment.)
Nevertheless, a shift in the Governor’s approach is perceptible. Ever since he became the central bank Governor, he had been sharply focused on inflation and inflation expectations and often resisting pressure from industrialists and perhaps the government too to reduce the Repo rate. On September 29th, Rajan sprang a surprise by reducing the Repo rate not just by 25 basis points as was hoped for by most, but by 50 basis points. This was a pleasant surprise to borrowers but a crude shock to savers of money because lending and deposit rates of banks are likely to move downwards.
This marked a break from Rajan’s record of consistency though he might say that a foolish consistency is the hobgoblin of little minds. Central bank chiefs are known to surprise the markets; they dislike their actions becoming predictable. Has Raghuram Rajan become a victim of this psychological bias?
As usual, the monetary policy statement notes contradictory economic signals. SouthWest monsoon has been deficient. But, the first advance estimates indicate that foodgrain production is expected to be higher than last year.
“Manufacturing sector has exhibited uneven growth in April-July, with industrial activity slowing sequentially in July, although it has been in expansionary mode for the ninth month in succession.”
“ In the services sector, construction activity is weakening as reflected in low demand for cement and the large inventory of unsold residential houses in some localities. Rising public expenditure on roads, ports and eventually railways could, however, provide some boost to construction going forward. Lead indicators relating to freight and passenger traffic are mixed. In August, the services PMI remained in expansion for the second consecutive month on improving new business, but business expectations remain subdued.”
If you are a bit confused reading this, don’t worry. As Alan Greenspan, a former Chairman of the US Federal Reserve System once famously said, “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant”. But it must be said to the credit of Raghuram Rajan that he is much less obfuscatory in his utterances than many of his peers, present and past, around the world.
RBI’s views on the relative significance of price stability and sustainable growth are expressed as follows: “Price stability is a necessary (if not sufficient) precondition to sustainable growth and financial stability. The relative emphasis assigned to price stability and growth objectives in the conduct of monetary policy varies from time to time depending on the evolving macroeconomic environment. Financial stability is important for smooth transmission of monetary policy. “
Choice of words exposes the overriding importance attached to price stability by RBI. It does not categorically say that price stability is not a sufficient precondition to growth. It only emphasizes the indispensability of stable prices as a precondition to growth and is tentative about the insufficiency of this precondition.
Two factors have enabled RBI to take the risk of reducing the Repo rate by a handsome half a percentage point with the confidence that inflation will not surge. One is the persistently negative output gap and the other is the deferral of much-feared increase in interest rates by the US Federal Reserve. Negative output gap means that actual output in the economy is less than the potential output (capacity utilization is about 70%) and therefore there is ample scope for supply enhancement even without augmentation of capacity. Since the US interest rates will continue to be near zero levels for some more time, there is no imminence of sharp depreciation in external value of rupee and consequent aggravation in cost of imports.
The monetary policy statement acknowledges that inflation is likely to go up after September in view of reversal of favourable base effects. As always, prudence of RBI’s present dovish stance will be confirmed or falsified only by future events.