THE OTHER SIDE
My first reaction to last week’s rate cut was that it was too little, too late. But I later felt that there are more serious issues in the thinking of the Monetary Policy Committee (MPC) behind rate setting. Let me start with the minutes of the June meeting of the MPC released in July. Viral Acharya, deputy governor of the Reserve Bank of India (RBI) and a member of the MPC, has been quoted as arguing that “tolerance for a slightly higher real rate of interest is justified to ensure that weak banks do not find relatively low the hurdle rate for evergreening of bank loans”. (Ever-greening means granting a fresh loan to avoid an existing debt getting classified as a non-performing asset.) How many cases of ever-greening have the central bank supervisors come across? Are they significant enough to “punish” the whole economy with high interest rates? And would high rates discourage ever-greening?
Also debatable is the definition of “slightly higher” real rates. The latest available inflation number (for June) is 1.5 per cent, a historic low. Thus, even after last week’s reduction, the “real” rate is 4.5 per cent. (For most bank borrowers it is much higher given the intermediation costs.) To be sure, the MPC has acknowledged its inability to arrive at a “conclusive segregation of transitory and structural factors driving the disinflation”. But since policy rates are meant for the future, let me turn to expectations about the future. Projected inflation rates for the second and third quarters are four per cent plus, and in the post-policy press conference Acharya said the central bank was comfortable with a real rate of 1.75 per cent. The question is, how reliable is the model the RBI uses for forecasting inflation. For sometime, it has consistently overestimated future inflation. (The record reminds me of what Galbraith said about economic forecasts in general — that they make astrology look more credible!) If even the past is unexplainable how much can we rely on the projections, which suggest a real rate of 1.75 per cent? When people believe in a theory and the models based on it, do they too often select the evidence that supports the conclusion?
As for theory and models, while releasing the annual accounts last month, the general manager of the Bank for International Settlements (BIS) said: “An obvious policy question at the current juncture is whether an inflation flare-up could bring to an end the expansion underway. This question, in turn, begs an even more fundamental one: How much do we really know about the inflation process?” And not only the BIS economists; author and fund manager Felix Martin, in a recent article ( Financial Times, July 28), argued that “the Philips curve (supposed to represent the relationship between unemployment and wage rises) has gone ignominiously flat. The world’s leading central bankers are scratching their heads”.
Or is the basic assumption underlying macroeconomic models, namely the rationality of economic agents — that is, you and me — untenable? To take one example from the domestic market, surely investing in a gold bond that pays interest and gives the same price return as gold itself is more “rational” than holding physical gold, which can also be stolen? And yet, since its introduction in 2015, aggregate sales have been just about ~60 billion, or less than $1 billion. On the other hand, last year alone we imported gold worth $27.5 billion! Rational? To be sure, humanity’s ageold fascination for gold is itself “a barbaric relic of human irrationality”, as Keynes said a long time back.
Coming to monetary policy in advanced economies, where the monetary transmission is supposed to be more efficient, huge increases in money supply are taking umpteen years for their effect to be reflected in prices. Has the speed of circulation of money dropped instead of remaining stable, as Milton Friedman had theorised? What the low interest rate policy in most of the advanced economies has done is increase demand for high-yield bonds, and credit risks be damned. Two recent examples of sovereign bonds: Argentina, a serial defaulter for two centuries, sold a 100-year bond; Iraq, a country at war, externally and internally, for a quarter century, with its economy in a shambles, successfully sold a six-year bond in the global markets. Is another bubble building up, this time in the bond market? And will it burst when rates start going up and the central banks become net sellers of bonds in the market?