Blunt instrument: have interest rate hikes run their course?
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Blunt instrument: have interest rate hikes run their course?

You may quibble with RBI governor D Subbarao about monetary policy being a blunt instrument that hits everything from individuals’ home loans to the country’s economic growth. Gautam Chikermane writes.

columns Updated: Jun 17, 2011 19:14 IST
Gautam Chikermane
Gautam Chikermane
Hindustan Times

You may quibble with RBI governor D Subbarao about monetary policy being a blunt instrument that hits everything from individuals’ home loans to the country’s economic growth. Or go along with him to make the cost of money in the economy so high that demand for goods and services falls and consequently, with a predictable lag, prices. Both have their economic arguments, well articulated in equations that economists sitting in their perfect world with friction-free information understand, debate and propound.

The real world, however, sucks.

Households are wondering how much they will have to squeeze their budgets that have already cut most of their discretionary spending like foreign vacations and second cars at the top end and eating out on the other. Statistically, this segment of households may not be large or concentrated enough to be able to influence the political economy. But it is this lot of middle class and above that’s driving much of the India growth story.

On the other side, a far larger number of households are having to deal with an inflation rate that, despite all efforts and promises by the government, is showing no sign of reducing. The last time we saw high inflation — it rose from under 4% in January 2003 to almost 8% in November 2004 — we were told that a fast-growing economy cannot have low inflation. At every rise in the inflation rate, the government told us, like it does today, that it will fall within three to six months. It didn’t happen then, it won’t happen now. We do need to remember that 850 million Indians live on less than $2 a day, whose vulnerability has pushed them to an economic edge.

Even the inflation-proofed voices of the corporate sector --- the guys who make the products we buy and who pass on to us all increases in prices and financial costs through periodic interest rate hikes like the one today --- are sceptical. “Interest rates are not an issue yet,” a senior leader told me yesterday. “The problem is elsewhere.” He was referring to the global commodity boom that has taken the prices of coal, fuel, iron ore as well as food high. He was also referring to the government’s paralysis on policy actions and reforms.

Economic policymaking in general and monetary policy in particular has changed in the past 10 years that have seen the global economy move from an era of relative predictability to one of constant volatility. So, Subbarao’s solution to increase interest rates 10 times in the past 15 months by 2.75 percentage points is not going to get us anything but a feeling of greater squeeze.

During the same 15 months, commercial banks increased their base rates faster, by 3 percentage points. And as far as the inflation rate goes, while it fell to 8.1% in November 2010 from 11.2% in March 2010, it has been rising steadily since then to 9.1% today. If any economist wants to draw a conclusions from this data, she will have to do so at considerable reputation risk.

Call it policy inertia or even the unwillingness to look at facts in the face, but the pain of rising interest rates is going to continue. Domestic fuel prices have not been factored in, global commodity prices remain in risky territory, Subbarao’s policy review said. “Based on the current and evolving growth and inflation scenario, the Reserve Bank will need to persist with its anti-inflationary stance of monetary policy,” it concluded.

“What is the problem we wish to solve when we try to construct a rational economic order? On certain familiar assumptions the answer is simple enough. If we possess all the relevant information, if we can start out from a given system of preferences and if we command complete knowledge of available means, the problem which remains is purely one of logic,” said Austrian economist Friedrich August Hayek in a September 1945 paper titled, The Use of Knowledge in Society. “This, however, is emphatically not the economic problem which society faces.”

In a March 1968 paper titled The Role of Monetary Policy, Milton Friedman wrote, “There is wide agreement about the major goals of economic policy: high employment, stable prices, and rapid growth. There is less agreement that these goals are mutually compatible or, among those who regard them as incompatible, about the terms at which they can and should be substituted for one another. There is least agreement about the role that instruments of policy can and should play in achieving the several goals.”

If inflation and interest rates were not mutually compatible in 1968, I presume they would be less so 43 years later, when global linkages between nations have become stronger and prices of goods in India are being decided in Australia (coal) or the Gulf (oil). Subbaro’s heart seems to be in the right place, but it is not going to control prices — not without unleashing new monsters of economic and employment slowdown.

First Published: Jun 16, 2011 21:36 IST