Tayloring central bank to meet growth objective

The government is trying to foist a little-used monetary policy formula on the Reserve Bank of India (RBI) in an attempt to force the central bank to trim rates.

By Saumitra Dasgupta
  • Published 20.10.17

The government is trying to foist a little-used monetary policy formula on the Reserve Bank of India (RBI) in an attempt to force the central bank to trim rates.

Since August 2 when it last cut rates, the RBI has dug in its heels and fobbed off calls to cut the policy repo rate from its current level of 6 per cent on the ground that inflation is going to trend higher in the second half of this fiscal and could top the 4 per cent medium-term target that it has set for itself by April next year.

The RBI's stance is based on two postulates: first, it has a clear mandate to focus on containing inflation and, second, there is no empirical evidence to suggest that a cut in interest rates will crank up the growth rate in a faltering economy.

The Modi government - under fire after India's growth rate slumped to 5.7 per cent in the first quarter (April-June), the lowest in 13 quarters - is slowly building pressure on the RBI to cut rates and ignite growth at a time when it doesn't have the fiscal headroom to crank up government spending after exhausting 96 per cent of its fiscal deficit target of Rs 5.46 lakh crore by the end of August.

Unlike the Federal Reserve of the US and the Bank of England, the RBI has a single mandate for the conduct of monetary policy: inflation targeting, a goal that was explicitly spelt out through an amendment in the RBI Act last year. Both the Fed and the BoE have a dual mandate in that they must strike a balance between inflation and growth (usually measured by using the proxy yardstick of employment).

So, how can the Modi government shoe horn the growth objective into the RBI's mandate without amending the act?

That is where the Taylor Rule comes in.

The Taylor Rule - named after Stanford University professor John Brian Taylor who articulated the basic concept in 1993 - serves as a rough formulaic guide to help central banks adjust their policy interest rates in response to developments in inflation and macroeconomic activity.

Incidentally, there is speculation that Taylor is being considered by President Donald Trump to replace Janet Yellen as chair of the Federal Reserve in February.

A key component in the Taylor Rule formula is the output gap - which is the difference between the potential output of an economy based on trend line in GDP growth and the actual growth rate.

The thumb rule for policymakers under the Taylor Rule is to raise rates when inflation is above target or when GDP growth is too high and above potential. Conversely, they should lower rates when inflation is below the target or when GDP growth is low and below its potential.

The idea now is to persuade the RBI to embrace the Taylor Rule or at least factor it into the policy-making process.

Even if no central bank explicitly follows a Taylor-type rule, several central banks like those in Australia and Canada, which were among the first in the world to adopt inflation targeting, tend to focus on output stabilisation while determining the trajectory of interest rates.

In fact, Taylor wrote a seminal paper in November 2008 which argued that if the Fed had started tweaking interest rates upward sometime in 2002 (using prescriptive models based on the Taylor Rule), then the housing boom wouldn't have happened that eventually precipitated the global financial crisis of 2008.

RBI governor Urjit Patel has already said that the policy makers do look at the "output gap" but are opposed to the use of a mathematical formula to determine what the interest rate should be.

"There is no clear hidebound mathematics that we must give 'X' weight to inflation and 'Y' weight to growth and form the associated policy. But what is clearly laid down is the 4 per cent inflation target; and we will strive to achieve that, keeping in mind the objective of growth. Growth is always there in the monetary policy committee's scheme of things; we don't lose sight of that, but not at the cost of inflation," he said in a post-policy interview with Mint.