The Monetary Policy Committee and Dr. Rajan's Axe Soup

First, let’s get today’s policy out of the way…

Given the explicit mandate of the MPC, today’s rate action was a foregone conclusion. 

After all, CPI will likely stay well above 4% for the next few months, so the MPC was bound to ignore all entreaties for rate cuts. 

The only question was on how hawkish would their commentary be – and on that, they seemed to meet analyst expectations.

…and then step back for a bit

The striking feature in all this is how much of public monetary policy discourse now revolves around CPI estimates and policy repo rate responses. And little else.

Never mind that CPI estimation in India effectively boils down to estimating future prices of food and other commodities. If we had a good model for that, we wouldn’t be wasting it on CPI estimates – we would be out playing the commodity markets.

But still, even if CPI outcomes are somewhat unpredictable, as long as we know that interest rates impact CPI’s broad direction, it’s still worth using rates as a lever, right? Right. And the impact of higher interest rates on Indian CPI should be obvious, right? 

Hmm… the only research that I have seen on this is from Mishra, Montiel & Sengupta (2016), who find that tightening monetary policy has NO significant effect on India’s inflation rate. Eh?

Gorky’s axe soup

There’s this old Maxim Gorky story of a Russian soldier trying to extract food from a stingy host. The host claims she has nothing in her larder. The soldier says he can make a soup from an axe that’s lying around. The host is intrigued, and plays along. Starting with boiling water and the axe, the soldier goes on to ask for a bit of salt, a bit of pepper, a bit of meat, some carrots, some onions and so on, until finally, lo and behold, a delicious axe soup is ready. Right in the beginning, of course, our intrepid soldier has quietly removed the axe from the broth.

Is our monetary policy framework somewhat similar? Here’s how that would play. We have our druids who can give us inflation control by using repo rates. We all watch agog. They then ask the government to control food prices. They spot some low oil prices lying around. They then ask the government to add a dash of fiscal restraint. They get a benign global environment. And lo and behold, we have monetary policy led inflation control.

Jokes apart..

Okay, so let’s not be silly. We need to take a closer look at the Mishra, Montiel, and Sengupta research. 

At some level, the research result may not be that surprising. After all, India is not a borrow-to-spend economy but a borrow-to-produce economy. Household debt is only 15% of GDP, while corporate debt is 56% of GDP. Will aggregate demand route for inflation control still work in this context? Or will interest rates end up as a higher input cost for borrowing producers, thereby negating the aggregate demand impact on inflation?

But I don’t think that’s the complete answer. I think the research needs to add some context. Even if aggregate demand route is weak, interest rates and the shape of the yield curve can impact a host of macroeconomic variables. High rates can penalize a runaway fiscal deficit and help control it. It can bring in foreign currency in search of carry, and hence buy some time before a blowout in current account deficit pushes our currency beyond the brink. It can help douse asset bubbles by choking leverage, particularly when used alongside macroprudential strictures. In other words, monetary policy can impact macroeconomic variables and lower inflation, under the right financial stability context.

But what if things are fine, with no immediate financial stresses on the horizon? Will high interest rates still be useful to proactively prevent excesses? Or will they start to build excesses of their own, including long INR carry trades, a stronger INR, and stifled investments on the supply side?

That’s where things get messy. Trying to model financial stability with twenty variables is complicated. It introduces more elements of doubt and subjectivity. After all, one woman’s equity market froth could be another woman’s reflection of our true potential. And politicians can thrive on this subjectivity to (mis)use monetary policy to improve their immediate electoral prospects. 


So maybe that’s what Dr. Rajan had in mind. Simplify the model into a CPI and repo rate one, even if it's a bit of an axe soup. As long as the government’s fascination for interest rates gets them to play along and build the soup with a dash of fiscal restraint and a splash of food price control, maybe everyone stays happy in the long run?

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