If Subbarao's a hawk, he should be raising interest rates

By Shanmuganathan Nagasundaram

It’s a universally-acknowledged “opinion” that a central banker who raises interest rates, or at least refuses to cut rates despite all-round calls for one, is a hawk. And true to script, despite almost desperate requests from the former finance minister, passionate appeals from industry lobbies like the CII on how lower rates will be good for the country (never mind the highly leveraged status of the companies run by CII honchos), the central bank did not cut rates last month.

Not one of the analysts polled before the policy thought that the central bank should raise rates, which is what this writer has been urging for months. Apart from raising rates, the Reserve Bank of India (RBI) should move to a fixed CRR (cash reserve ratio) regime, instead of tinkering with it all the time. It would be even better if it abolished paper money - created by the printing presses - but this would be a really outlandish suggestion for the current crop of central bankers who love to print money.

Apart from a 50 bps (where 100 bps make 1 percent) reduction in repo and CRR a few months back, the RBI Governor, D Subbarao, has maintained a steadfast “do nothing” attitude towards monetary policy. So is he really an inflation hawk, as proclaimed by the media?

For starters, if he is really a hawkish central banker, why is inflation hovering at around 10 percent? And that too at a time when the GDP growth is substantially below the RBI’s own estimate of India’s potential growth rate (by the way, I think this theory of potential growth rate and all that is completely bogus, but I will reserve commentary on that for a later date).

Before answering in a structured way, here are a few examples of how actions at the margin should never be used to interpret the actions of central bankers. I am using extreme examples, but readers should understand that raising rates doesn’t necessarily qualify as a hawkish move and cutting rates doesn’t imply a dovish move. The Zimbabwe central bank has probably been raising rates for the last several years and that hasn’t exactly brought stability to the currency.

At the other end of the spectrum, I would have to quote the Bundesbank (the erstwhile German Central Bank) that maintained very low interest rates for an extended period and still had a relatively stable currency.

So who qualifies as a hawkish central banker? A central banker who can maintain the interest rate at a level that limits the growth rate in M3 (a broad money measure) to the rate of GDP growth would be a hawkish one. The rationale is fairly straight-forward: the definition of inflation is “the excess supply of money and credit relative to the goods and services produced within the economy” - or at least that’s the way the Austrian Mises Institute would have defined it.

Like the proverbial camel’s nose under the tent, the definition was modified to include “resulting in higher prices”. And, of course, with the passage of time, the causal factors were deleted and now we just define inflation as “rising prices”. With the new definition in place, it’s always decidedly convenient to determine who caused the inflation. Of course, it’s the greedy multinationals, oil cartels, droughts, speculators, growth, etc.

So with M3 expected to grow at 16 percent or thereabouts and with GDP growth at 6 percent, it’s easy to see that the RBI is actually targeting an inflation of 10 percent. So unless the RBI can raise interest rates to bring down M3 growth rates, or we are surprised on the growth front due to fiscal and policy actions of the government, inflation is going to hover around 10 percent.

We will have ups and down to this number, but given the current monetary policy, expecting a dramatically different outcome isn’t logical.

So what should the RBI Do?

The answer is ‘Raise rates’. As I have written earlier, the growth prospects for the Indian economy appear none too favourable. Given the global headwinds as well as our own policy predicaments, 5 percent is the best case for Indian GDP growth for this decade ( Can we do a China? ) And there’s substantial and probable downside risk to that 5 percent estimate. If the RBI continues with this do nothing policy, we run the risk of becoming an Argentina (that incidentally has had interest rates at 9 percent fixed for several years now and still faces galloping inflation at 20 percent plus).

So what will happen to growth? It will falter, but with the current negative real interest rates, we are inducing malinvestment and misallocation of capital that India can ill-afford at this juncture. The price to pay when these bubbles burst would be that much heavier if we postpone the day of reckoning with artificially low interest rates. Whether Subbarao can summon the intellectual fortitude to undertake such actions is another matter altogether.

In what is one of those endearing cinematic moments, in the movie Saving Private Ryan, Captain Miller, played by Tom Hanks, explains the sacrifice of the US marines in trying to save the life of Private Ryan. Similarly, Subbarao has been bestowed the honour of being called a hawkish central banker. Undeservedly, as I have explained. I am no Captain Miller, but Mises might as well tell Subbarao to “earn” the title.

Shanmuganathan “Shan” Nagasundaram__is the founding director of Benchmark Advisory Services - an economic consulting firm. He is also the India Economist for the World Money Analyst_, a monthly publication of_ International Man_. He can be contacted at__ shanmuganathan.sundaram@gmail.com _