Subbarao: Mood for debate
Mumbai, Aug. 30: Reserve Bank of India (RBI) governor Duvvuri Subbarao has bowled another googly at his critics. Using arcane economic theory, he has said that he could argue that his monetary policy – far from being hawkish – is actually accommodative.
And the outgoing central bank governor says it isn’t him but the International Monetary Fund (IMF) that has made this assertion in its Article IV Report released in February this year.
The dizzying twist in the interpretation of the RBI’s monetary policy stems from the use of what economists call the Taylor Rule.
Delivering the inaugural address here today at the Seventh Statistics Day conference which is held every year to honour the memory of Prof P.C. Mahalanobis, Subbarao said the IMF Report acknowledged that India’s repo rate of 8 per cent on September 14, 2012 was less than the rate implied by the Taylor Rule, thereby indicating that the “RBI’s monetary policy stance has been accommodative”.
“Contrast this with the criticism in several quarters in the past that the monetary policy was tight,” he added.
The Taylor Rule, a formula developed by Stanford economist John Taylor, is an interest rate feedback rule that aids in determining short-term interest rate to achieve the objectives of stabilizing the economy and achieving price stability.
The use of the Taylor Rule requires an assessment of three indicators: output gap, inflation target and the equilibrium real interest rate.
The rule recommends that that the short-term interest rate should be changed according to the deviation of inflation from its threshold or pre-determined target and of output from its potential level.
In essence, the Taylor Rule suggests that the “combination of inflation and output gaps should determine the appropriate policy rate that would return the economy to its potential level without causing excessive inflation.”
It has recommended tightening of the policy rate (in India’s case-the repo rate) if inflation in a country is above the targeted rate or when an economy witnesses and employment over the full level and the reverse in case of an opposite situation.
Output gap is the divergence between actual and potential economic growth.
The potential output of an economy is defined as the maximum sustainable level of output that is consistent with stable inflation. In 2009-10, the RBI had reported that the potential output growth of the Indian economy may have dropped from 8.5 per cent pre-crisis to 8 per cent post-crisis. “Our latest assessment suggests that the potential output growth may have further declined to around 7 per cent,” he added.
He added that the threshold level of WPI headline inflation in India is in the range of 4.4 to 5.7 per cent, implying a mid-point of 5 per cent.
Critics of Subbarao from the industry and the government have averred that his monetary tightening measures that were undertaken from 2009 affected growth even as it was not successful in easing inflationary pressures.
Subbarao, who will step down from the post on September 4, had said in his last public lecture as RBI governor yesterday that though growth in the economy had moderated, it would be “inaccurate, unfair, and importantly, misleading as a policy lesson” to attribute all of the moderation to tight monetary policy.
The outgoing governor also opened up the discourse on inflation by suggesting that the RBI could consider framing its monetary policy on the basis of inflation measured by the consumer price index (CPI) rather than the wholesale price index (WPI).
While the RBI now uses the wholesale price index (WPI) number to calibrate its monetary policy, there have been suggestions to use the consumer price index (CPI) as it is considered to be a better indicator of the cost of living, thereby better reflecting the welfare objective of monetary policy.
However, Subbarao conceded that based on the present composition of CPI in the country, it is difficult to base monetary policy decisions on this number.
“The new CPI inflation series has only 19 data points which is not sufficiently long for statistically robust analysis. Second, in the new CPI, food prices comprise nearly 50 per cent of the index, making the movement of CPI relatively more sensitive to food price changes. This implies that the influence of supply-side factors could dominate the trends in CPI,” he added.
Commenting on exchange rate which is now the centre of attention, Subbarao said that no single statistical measure of equilibrium exchange rate can be an acceptable reference point for all purposes. In a market determined exchange rate regime, any level of exchange rate at any point of time is an equilibrium value, reflecting the interactions of demand and supply.
However, there are other approaches in this regard. For instance there is a fundamental equilibrium exchange rate (FEER), which says how mis-aligned the market exchange rate may be at any point of time.
John Williamson, who pioneered the concept of FEER, emphasised that the equilibrium rate is the rate which is consistent with full employment or full potential growth with low and stable inflation - and a sustainable external balance position. This approach, however, ignores cyclical and speculative factors in determining the exchange rate path.
Subbarao said there were several other statistical models to measure the equilibrium exchange rate but none were acceptable as an acceptable reference point for all purposes. “The challenge for statisticians would be to design one or more constructs whhc provide the ‘best’ possible measures of equilibrium exchange rates,” he added.