Raghuram Rajan did the right thing - but it's not enough

By Shanmuganathan Nagasundaram

For pretty much over the last few decades, all that we have heard from the Reserve Bank of India (RBI) is what I would categorise under the category of mumbo jumbo economics. RBI Governors would routinely discuss the mythical growth-inflation tradeoffs that they have to manage and the media in general would pretend that we have hawkish governors despite the dramatic fall in the rupee’s exchange value over the decades. The most absurd pronouncement came from Dr Manmohan Singh who had observed recently that inflation is not much of a problem as wages have largely kept pace.

Governor Raghuram Rajan’s actions largely (despite some misgivings that I have outlined previously) and the Urjit Patel committee’s recommendations on monetary framework represent a very welcome change in that context. To reunite the umbilical cord of monetary policy with monetary stability was a huge positive step that had unfortunately been severed under the tenure of previous governors. That, and the increase in repo rates (though I would have preferred a much steeper pace of increases), have brought about a semblance of balance to the purpose of monetary policy.

But are these steps adequate for the challenges that lie ahead? I doubt it.

2014 & beyond: Still suffering from the reverberations of the 2008 credit crisis, it appears that the underlying factors leading upto those events have been forgotten. I have to point out that the causative reasons of excessive credit and leverage have only been magnified in the intervening period. Instead of using this period to deregulate and get government finances in order, most governments, and particularly the US, have only used the rather generous rope extended by Mr Market to build a bigger and stronger noose for themselves.

The foundations of the US economy have been impaired on a near-permanent basis and there is little of hope of a solution without a serious currency crisis. With an acknowledged national debt of over $17 trillion, there is no way the US can afford an increase in interest rates for the foreseeable future.

The US economy has been on ventilator support of near zero percent interest rates for a few years while the costs of the same have been temporarily masked due to the ultra-low velocity of money. There are any number of pins that can prick this bubble economy and the underlying debt bubble, the unravelling of which would have disastrous consequences for the world economy. As they say, the 2008 crisis would appear to be a Sunday school picnic in comparison.

It is in the context of this problem that we should view the adequacy of the steps taken by the RBI. But before getting into that, readers could legitimately wonder that if Raghuram did predict the 2008 crisis, he would know how to deal with it.

Yes and No. Many had warned about the 2008 crisis, but only a subset got the reasoning’s, and hence the solutions, right. Anybody who had approached the issues with a non-Austrian School (Ludwig von Mises) background would have erred in their recommendations and Raghuram Rajan falls squarely in that category.

What should the RBI do? Two sets of corrections need to be done to the Urjit Patel committee’s recommendations. First, is the inflation target of 4 percent with a band of 2 percent (which would inevitably always mean 6 percent and not 2 percent). It is simply too lax. And the timelines for reaching that target are even more worrisome – we may not have luxury of two years before we have another crisis on our hands.

A much more preferred target would be an inflation target of 2 percent (I would have said zero percent, but most observers have been scared to death of deflation due to the propaganda of Central banks, but I will talk about that on another date) with a band of 1 percent. If inflation is the unkindest of taxation systems, and I agree whole-heartedly with Raghuram Rajan’s observations on this, then there really is no excuse to use a more conservative band than the one suggested by the RBI.

The other issue that I would prefer a change in is the use of the Consumer Price Index (CPI) for targeting inflation. Ironically, I would agree with finance ministry officials that the CPI is not a good indicator of inflation. There have been plenty of situations where the underlying causative factors would have been growing berserk while the CPI numbers appear benign. The CPI acts with a lag in both directions and hence it’s really not a good measure to target inflation.

I think we should use the more traditional and causative factor of “excess money supply” to measure inflation. So if the RBI thinks we would be growing at 5 percent or thereabouts, and if it wants to target an inflation of 4 percent, then it should put interest rates at a place that would limit the M3 (broad money supply) growth to 9 percent. Given current M3 growth rates of 15 percent and growth of 5 percent, I would have to state that CPI is still understating the extent of the problem, although mildly.

Near the end of tightening Cycle? Unlikely. Though Raghuram Rajan has indicated that there is likely to be a pause in rate tightening measures, I don’t think that should be the case. The data that is likely to emerge over the next few months is likely to warrant more hikes in the months ahead.  There really is no other way for the RBI to force the government to gets its house in order other than by raising rates.

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