Decoding India’s monetary economics

Over the past five years, India has seen something of a revolution in terms of the formulation of monetary policy. Today, we have a central bank with a clear mandate, to control inflation — and the government has formally signed on to this mandate. Monetary policy is set by a committee, half of the members of which are independent economists. This is also the period in which, partially but not wholly coincidentally, inflation has fallen considerably.

It is clear, however, that in spite of the modernisation of India’s monetary policy apparatus and the introduction of best-in-class approaches, the theoretical framework through which monetary policy is analysed in India is not on sufficiently sound foundations. The prevalence of acrimonious open debates on the motivations and future directions — and even past accuracy — of monetary policy-making is evidence of this fact. It is vital for central bank actions to be predictable — which needs the framework, assumptions and environment in which it operates to be properly theorised and understood.

A major contribution to this effort has recently been published, in the shape of a Springer volume entitled Monetary Policy in India: A Modern Macroeconomic Perspective( henceforth MPI), edited by Chetan Ghate and Kenneth M Kletzer. (Prof Ghate is now one of the members of the Monetary Policy Committee, but it appears that the Introduction of this book was written well before that appointment.) Besides the Introduction and a Foreword by the distinguished economist John Taylor — the creator of the Taylor Rule — the book contains 18 essays written by leading macroeconomists and policy analysts. While academic in tone, and containing their fair share of rigorous models and empirical work, the essays are by and large accessible to laymen.

I would go further: The book should be required reading for those observing India’s macroeconomy, as well as an essential possession of those who are involved in making policy for/dependent upon India’s macroeconomy. The essays do not get lost in history, but thoroughly ground current Indian macroeconomic developments in up-to-date economic theory; they identify where the theory may be inapplicable to Indian conditions, and in some cases effectively demonstrate how that problem could be overcome.

Naturally, a summary of these 18 essays is impossible in this review. However, it is possible to indicate one or two of particular interest — defined, of course, extremely subjectively. The hardwon independence of the Reserve Bank of India does not mean that it is no longer, in many senses, still answerable to decisions taken in New Delhi. This dominance of fiscal over monetary policy continues most sharply in the need to monetise large government deficits — an issue that is very much in the news, given the recent expansion of the government’s borrowing programme. A chapter written by Amartya Lahiri and current RBI Governor Urjit Patel develops a model of policy-making that concludes that a binding statutory liquidity ratio (SLR) requirement combined with fiscal dominance means “the transmission of monetary policy to the economy becomes… scrambled, with inflation potentially responding to [rate changes] in non-standard ways.” In fact, a possible outcome of a rate cut in this scenario is a contraction of demand and output.

Another author of a chapter in MPI who now has a senior policy-making role is Viral Acharya, who with Krishnamurthy Subramanian examines the risk to, and the systemic risk posed by, public sector banks (PSBs). Among their suggestions is that PSBs “be weaned off their funding advantage coming from government guarantees”, perhaps by “requiring them to pay a deposit insurance premium”.

Another examination of how the reform agenda that New Delhi has left incomplete impacts the conceptualisation and implementation of monetary policy is provided by Rahul Anand, Sonali Das and Purva Khera of the International Monetary Fund. The authors construct a dynamic stochastic general equilibrium model of an economy like India’s, with high entry costs for companies and high costs to firing employees that unnecessarily and significantly raise the overall negative effect on output of inflation-fighting. In other words, tight monetary policy is far more harmful for output than it needs to be because the government has failed to reform India’s archaic and restrictive labour law.

Perhaps the MPI chapter with the most “news” value is the one from Sajjid Chinoy, Pankaj Kumar and Prachi Mishra on the disinflation between 2013-14 and 2014-15. They argue, counter-intuitively, that the oil price decline was responsible for only two per cent of the fall; the big determinant of the disinflation was a “moderation in the historical dynamics of inflation” — in other words, lower past inflation changed current consumer behaviour and thus lowered current inflation. (Institutional factors also come into it) I have some quibbles with the methodology here, but this chapter is accessible, rigorous and intriguing.

Overall, I cannot recommend this volume enough. As with all sharply topical academic work, you can feel the lack of analysis of very recent developments — perhaps, if commissioning today, the editors would examine also how a flood of sovereign and quasi-sovereign debt can affect the bond market and monetary policymaking, for example. But overall I am yet to come across a better high-level treatment of India’s macroeconomy.

MONETARY POLICY IN INDIA

A modern macroeconomic perspective Chetan Ghate and Kenneth M Kletzer (editors) Springer India, 2017

652 pages; ~15,000