The recent speech by Joseph E Stiglitz at the 15th CD Deshmuk Memorial Lecture at RBI is notable for the frontier observations on financial regulation and monetary policy implementation. The speech, titled “A Revolution of Monetary Policy: Lessons in the Wake of the Global Financial Crisis”, is concentrated on current phase of financial regulation in the global context.  Stiglitz has given an in-depth view of the current phase of financial regulation among the central banks.   

          But a remarkable part of the speech was that on monetary policy which should not be left unnoticed. It contains discontents about the manner in which central bank frames monetary policy in this difficult times. Here, Prof. Stiglitz has highlighted some weaknesses of contemporary central banking practices in emerging market economies with regard to monetary policy implementation. Stiglitz’s speech highlights some wrong trends from which central banking should be freed.  

          Firstly, Prof. Stiglitz has attacked central banks for blindly focusing on inflation by disregarding other priorities like growth and employment. He has pointed out that implementation of monetary policy unresponsive to other objectives has produced welfare losses for the people. His justification for getting away with the traditional format of too much focus on inflation fighting is that it has produced more costs. The costs of inflation fighting were significant and they are often left uncounted. Besides, the prevailing supply side instabilities makes monetary policy inefficient.

Stilglitz urges central banks to consider other important macroeconomic priorities like growth and employment than focusing on inflation only. The costs of inflation control in the form demand compression and welfare losses are bigger in the context of the current slowdown.

          He maintains that inflation fighting is a coordinated effort of the government and the central bank. Stiglitz urges central banks to conduct monetary policy by addressing the challenges brought by recession. So, inflation should not be the stand alone objective.

          Secondly, he has cautioned central banks of the developing world for zealously imitating their developed country peers.

          Thirdly, on the issue of the ongoing attempts made by central banks including RBI to attain independence, he reminded that it is the Western central banks that enjoyed independence which have failed during the 2008 crisis. On the other hand, the central banks of the developing countries- China, India and Brazil, with less independence were able to withstand the crisis.

Success in financial regulation and failure in inflation fighting

          Altogether, the observations made by Prof. Stieglitz on monetary policy implementation seems to be a stunning attack on the monetary policy of the RBI if it is carefully analyzed with the manner in which it is implemented in India during the past few years. 

Stiglitz has lauded the emerging market central banks for being successful in overcoming the crisis of 2008. As per his judgment, the RBI has emerged as a model for financial regulation amidst ruins in the west. Its regulations are now tested by time. But a backgrounder of economic regulations in India reveals that strong regulations are inherited by institutions in the country. Strong regulation is the main feature of the entire macroeconomic institutional mechanism in India. The industrial licensing policy, trade policy, public sector policy all are featured by strong regulations. The RBI has retained these traits in its financial regulation over the last 50 years. Incidentally, the 2008 crisis rewarded the RBI benefits of strong regulation.

          Coming to the monetary policy front, the achievements of RBI in inflation control remains meager. So far, it was able to cover up its failure in monetary policy by putting the blame on the ongoing global financial crisis on the one hand and by highlighting the inherited regulatory strengths on the other. If the RBI is zealous in showcasing the achievement in financial regulation; it should equally courageous to admit its failure in monetary policy implementation.

Central banks should broaden their objective beyond inflation

          Undoubtedly, the major criticism as well as a suggestion made by Prof. Stiglitz is that central banks should look beyond inflation. For him, the central banks also should focus on growth and employment. “In the aftermath of the crisis, it is evident that the single minded focus of some central banks on inflation was misplaced”.  He adds that single minded attention on inflation creates instability than stability. “By diverting attention from what was really important, inflation targeting may accordingly not only have failed to enhance macro-stability, it may actually have contributed to instability.”

          Prof Stieglitz’s attack on the inflation focused monetary policy and its destabilizing effects are more specific on India as he discredits such a policy in the case of supply shocks. According to him “…developing countries exposed to supply shock which results in imported inflation increased interest rates, slowing the economy down even more, and imposing even greater costs on workers already suffering from high food and energy prices.” It is evident that the RBI has followed high interest rate oriented inflation fighting policy during the last three years amidst the pressure from imported inflation and the existence of supply shocks. Stiglitz describes the situation as one of “the cure would have been worse than the disease.”

          Stiglitz traces a leading post crisis monetary policy trend among developing country central banks. For him, these central banks are imitating the cult of inflation targeting embraced by their advanced country peers. Already, many academicians are indicating the central banks of emerging world are adopting inflation targeting of different variants.

          Inflation targeting monetary policy framework is followed by central banks in advanced countries and a few emerging market central banks. Under it, the key instrument is the short run interest rate (repo). The monetary transmission process starts with the central bank raising policy rate (short term interest rate) to target inflation. Increase in short term interest rate raises the prevailing market interest rate.  In the next stage of the transmission mechanism, increased market interest rate represented by lending rates depresses consumption and investment and thus aggregate demand. The resultant decrease in income ensures decline in inflation.  

          The same philosophy of inflation fighting has been stressed by Dr Subbarao in his speech at IIM Kozhikode last year when he advocated that sacrificing GDP in the short term is a small price necessary for reign in price rise. Over the last few years, the RBI is spiritedly focusing on inflation fighting disregarding the loss of growth and employment that they have produced in their fight against inflation.

          Monetary policy implementation in India over the last three years thus reveals the single minded focus made by RBI on fighting inflation. Clearly, the high interest rate policy adopted by the RBI has so far depressed private expenditure- both investment and consumption. The current debate about the so called conflict between growth and stability is because of the RBI’s uncompromising stand on sacrificing growth to fight inflation. The RBI has stick on to the philosophy of reducing growth to stabilize the prices-a practice commonly adopted in inflation targeting countries. Unfortunately, the short term interest rate using inflation fighting exercise by the RBI has not yielded any visible impact. Inflation continues to be at high level. Remarkably, the period since 2010 March is the longest period in recent history where high inflation and declining growth rate coexisted with high interest rate.

          We should be accommodative of the RBI’s management of the inflation scenario and need not be worried of losing a little bit of growth while ensuring medium term price stability. But how long and deeper should be the loss of GDP growth in ensuring price stability is a relevant question to evaluate the effectiveness of the present inflation fighting strategy.

Mohanty (2012) himself has made a study about the effect of interest rate policy by the RBI on GDP growth and inflation. His analysis (mentioned in RBI  Annual Report 2011-12) shows that a policy rate(repo)  increase by the RBI had produced negative effect on output growth with a lag of two quarters and a moderating effect on inflation with a lag of three quarters. Indeed, an examination of the policy rate’s effect on output and prices in India during the last two years on the basis of Mohanty’s predictions is enough to assess the working of inflation targeting measures.

           RBI has launched the present hard interest rate phase in March 2010. Then it started the now famous thirteen times upward revision of the policy rate relieved a little in April 2012. The initial stages of the policy rate increase can be considered as restoration of the rate to normalcy or a part of the exit strategy from the accommodative monetary policy stance during the financial crisis period. If the normal policy rate can be taken as 6% in the Indian context, the repo rate increase to 6.25% on November 2, 2010 is the beginning of the high interest rate regime effectively. The rate has increased to the peak 8.5% in October 2011.  Invisibly, the RBI’s monetary policy framework has been converted to a near inflation targeting variety since 2010.  

          There is no doubt that GDP growth rate has responded well to the policy rate hike as quarterly growth rate has came down  to 6%. But on the price front, as per the predictions of Mohanty, the time for interest rate increase to hit inflation (three quarters) has well passed, but the price level continues to rein at high levels. Even after eight quarters of launching the high interest rate oriented inflation fighting or almost four quarters after making interest rate signal at its peak, inflation has not been responded to monetary policy.

          Thus, price level responses to monetary policy interventions in India shows that inflation-interest rate relationship definitely is not in accordance with Dr. Mohanty’s predictions. Monetary policy interventions continue to be random experiments in the application side. In essence, the high policy rate pursued by the RBI since the last two years has killed growth without killing inflation. The economy has entered into a stagflation phase.  

          Prof. Mohanty need not be blamed for the failure of the VAR predictions to explain the non-responsiveness of inflation to interest rate hike. Monetary policy models at best remains approximations than accurate forecasters. The reason why inflation continues to be unabated despite strong use of interest rate medicines is simple. The RBI fights inflation in a developed country format, disregarding demand supply relationships in India’s emerging country setting. About the failure of such models as well as its disutility, Prof. Stilglitz observes that the models on which the central banks rely haven’t given than the prominence that they should.  For him, the belief of central banks that keeping inflation low was necessary and almost sufficient for stable and strong growth has been shown to be wrong.

          But the worst outcome of monetary policy implementation during the last three years is not just the decline growth produced by the RBI in its effort to contain inflation. Rather, it is the RBI’s inability to explain properly why inflation remains at high levels despite keeping interest rate high for a long term to depress demand and growth.

                    The policy prescription from Prof. Stiglitz is very clear in the Indian context. Given the inability of the RBI to contain inflation, it should not be allowed to curtail growth limitlessly in the pretext of inflation fighting by continuing with the present high interest rate regime. His suggestion that central banks should broaden their objectives beyond inflation is very important to associate the otherwise price stability addicted central banks with fiscal authorities to revive the recession hit economies. Justifying the possibility of failure in inflation management, Stiglitz reminds that monetary policy is not a ‘technocratic matter’.  “While monetary policy is an effective instrument in containing output, it may be far less effective in stimulating the economy in deep downturn.”      

          Stieglitz’s speech provides a worthy message in framing macroeconomic policies to revive the economy in the post crisis phase. We should not continue to waste our time and effort for a policy which is yet to prove its authenticity scientifically in its fight against inflation. As per Stiglitz‘s warning, it appears that the costs of inflation control is like sands in the wheels of economic growth. Hence, we should stop the RBI in becoming an institution which blocks the economy travelling back to the growth track. For the time being, rather than inflation, growth is the priority. Stieglitz is correct and bold as he made his points at the right place and at the right time. Is somebody hearing?

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