Robert Mundell and RBI’s impossible trinity
In the first week of April, legendary economist Robert Mundell passed away. In 1999, Mundell was awarded the Nobel Prize for his work on how monetary and fiscal policy works under different exchange rate systems. He is also seen as the father of the Euro. For generations of economists and policymakers, Mundell holds an exalted position for his work on the impossible trinity. He said that policymakers can choose any two, but not all three, macroeconomic objectives — foreign capital mobility, fixed exchange rates and inflation management.
What was a mere academic idea soon acquired practical relevance as economies had to choose from these three objectives. This was particularly true in the 1990s when foreign capital mobility became a popular policy reform. Economies made choices based on their conditions and aspirations. The United States (US) chose inflation and foreign capital mobility and kept exchange rates flexible maintaining the status of the US dollar. China chose inflation and fixed exchange rates to keep its exports competitive while keeping capital controls. Hong Kong chose free capital mobility and fixed exchange rates.
India did not make these choices. The Reserve Bank of India (RBI) maintained foreign exchange reserves and intervened in foreign exchange markets to stabilise the rupee. The capital account was not fully liberalised, preventing hot inflow and outflow of foreign capital. In 2003, the government announced the Market Stabilisation Scheme (MSS), which absorbed the excessive liquidity resulting from RBI’s interventions in the forex market. In 2016, RBI adopted the inflation targeting framework (ITF). Under ITF, central banks typically choose price inflation and free capital mobility and leave the exchange rate to markets. However, learning from the 2008 and 2013 taper tantrum crises, RBI continued to build foreign exchange reserves to safeguard from excess volatility of rupee and capital flows.
Over time, Mundell’s classical macroeconomics trinity has been adopted to understand trinities (or trilemmas) in other sectors. Dani Rodrik’s political-economy trinity is based on democracy, national sovereignty and global economic integration. Dirk Schoenmaker shows the incompatibility among financial stability, financial integration and national financial policies.
Recent central bank policies can also be reframed as another trinity — of inflation targeting, liquidity and government bond interest rates or yields. Large government deficits are pushing yields upwards. Higher yields lead to overall higher interest rates, which, in turn, threaten economic recovery.
Central banks are caught in this crossfire to keep the yields low. If central banks increase liquidity to bond yields, they give up on inflation targeting. If central banks focus on inflation and liquidity, they give up on yields.
The central banks of Japan and Australia target yield curves by flooding liquidity whereas those of England, the US and Europe do so implicitly. It is interesting that inflation has not really risen despite such easy monetary policies by these central banks.
In the case of RBI, the trinity choices are not as straightforward. The pandemic led to a large increase in government borrowing, which put upward pressure on bond yields. RBI managed this trinity by increasing liquidity via multiple programmes, keeping bond yields low. This was at the cost of almost ignoring the inflation target, which remained above the upper target range of 6% from April, 2020 to November, 2020. The markets also ignored high inflation and supported RBI’s efforts to support the weak economy.
The government announced high borrowing for 2021-22 as well, continuing to put pressure on RBI. This time, the bond markets demanded higher yields as the economy was recovering sharply — though the impact of the second wave of Covid will have to be seen. However, the government wished to keep the 10-year yield at 6%.
RBI was once again caught in the middle of this battle. It was as if RBI was Brahma mediating between Shiva and Vishnu (and I leave it to readers to decide who is who). As earlier programmes had diminishing marginal utility, in its April policy, RBI announced a new programme named Government Security Acquisition Programme (GSAP 1.0).
GSAP is nothing but old wine in a new bottle as it provides a calendar for the age-old Open Market Operations (OMO) that absorb and infuse liquidity in markets. Post-GSAP, the bond yields eased to 6% levels but again rose to the 6.10%- 6.15% range, tracking the rise in inflation. We are also witnessing interesting games between the government, RBI and bond markets in every bond auction.
But how long can RBI ignore inflation, given it is an inflation-targeting central bank? In a recent bulletin article, RBI economists said that the central bank is “striving to ensure an orderly evolution of the yield curve, but it takes two to tango and forestall a tandav”. This was a colourful way to express the tussle, with RBI putting the onus back on the markets. But it should realise that the markets are seeing the inconsistency in the RBI’s choices.
Mundell showed this nearly 60 years ago — when confronted with three objectives, you can, sometimes, just choose two. Given RBI’s objectives, it should pick inflation and liquidity and leave bond yields. Otherwise, the tango will eventually turn out to be a tandav.