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RBI vs finance ministry: What does the Taylor rule say?

LiveMint logoLiveMint 12-06-2017 Tadit Kundu

The Reserve Bank of India (RBI) is in the eye of a storm once again. The decision of the monetary policy committee (MPC) headed by RBI governor Urjit Patel not to lower policy rates in its meeting last week attracted sharp criticism from North Block, where the chief economic advisor to the finance ministry, Arvind Subramanian, questioned the wisdom of the move.

Disagreements among India’s top policymakers over the appropriate interest rate are neither new nor entirely unexpected. Given their mandate to target inflation, a central bank is prone to being hawkish about interest rates. Governments, especially in countries such as India with high fiscal dominance, typically prefer lower rates because they tend to be the largest borrower in the economy. When uncertainty over growth rises, such differences can become sharper, as seems to be the case now.

At such times, it is useful to consider what an apolitical policy rule such as the Taylor rule suggests about the appropriate interest rates for the economy. This yardstick, developed by Stanford University monetary economist John B. Taylor, estimates the desired level of interest rates based on two parameters: first, the output gap, or the difference between actual output and potential output, and second, the inflation gap, or the difference between actual and targeted rate of inflation.

As the chart below shows, the Taylor rule suggests that Arvind Subramanian is right to call for interest rate cuts.

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Obviously, setting interest rates is a complex issue and it would be naïve to assume that any one rule can authoritatively settle the debate over what a central bank should do. There is even dispute among economists over whether a rule is warranted at all, given that discretion in policy making might be useful to provide desirable “shocks” or surprises to markets as and when required.

Nonetheless, a monetary policy rule can serve as a useful benchmark. The attractiveness of the Taylor rule springs from two reasons: one, it is a widely used benchmark globally, and two, Indian policymakers, including RBI officials, have often referred to it in the past while discussing what the desirable policy rate should be.

As the chart above shows, today the gap between RBI’s policy rate and the rate path prescribed by the Taylor rule is at its widest in nearly two years. This is not so surprising given that consumer price (CPI) inflation has been below the 4% target for more than six months now.

Even though the wholesale price index (WPI) shows a higher inflation rate today compared to the CPI, even a WPI-based Taylor rule suggests that interest rates may be more than warranted.

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Of course, it could be argued that as monetary policy operates with lags, low inflation at present need not necessarily warrant an interest rate cut if inflation is forecast to rise going ahead. In fact, the forecast released by RBI in its latest monetary policy statement suggests that inflation might rise in the second half of 2017-18. However, the problem with this argument is that RBI’s recent inflation predictions have often been off the mark and that too consistently on one side—it has been repeatedly overestimating inflation. For example, in its December 2016 meeting, the RBI said “headline inflation is projected at 5 per cent in Q4 of 2016-17 with risks tilted to the upside”, while actual inflation in that quarter eventually averaged 3.6%.

The other big consideration for rate decisions—apart from inflation and growth—is exchange rate pressures. Often, it is prudent for a central bank to maintain a hawkish stance when the currency faces depreciating pressure. But if at all the rupee faces any pressure today, it is one of appreciation rather than depreciation.

Given the macro-economic trends, and the rising pressures from the finance ministry for a rate cut, it remains to be seen how long the RBI will maintain status quo. The bond market seems to have made up its mind already, and has started pricing in the possibility of rate cuts over the new few months.

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