Financial stability and the RBI (The Hindu)

Mains Paper 3: Economy
Prelims level: Reserve Bank of India
Mains level: Role of RBI

Context

• The Reserve Bank of India (RBI) recently carried out its mandatory bi-monthly announcement on the future course of monetary policy.
• These ostensibly offer ‘forward guidance’ to economic participants, so that they may plan their future.
• Arguably, though, the public would have perhaps been more interested in knowing how the RBI intends to respond to the unusually large number of instances of fraud that have surfaced in the financial sector of late.
• The RBI’s reputation as a regulator has been affected by these. What led the bank to this place needs understanding.

Role of a central bank

• How in a democracy so much power could be ceded to an unelected body must itself come as a surprise.
• It reflects two things: the political power of financial interests in the U.S. economy and the global intellectual influence of the American economic model.
• This model revolves around the goal of maximum creation of wealth by private individuals unimpeded by societal objectives.
• Leave alone the distribution of income, not even the objective of ensuring stability of the economy is allowed to come in the way of private individuals pursuing wealth enhancement.

Public regulation

• It sets limits to private activity, is rejected as an unnecessary interference in beneficial activity that maximises social gain, and is therefore to be avoided.
• When applied to finance, this model requires of the government only one action, namely, the control of inflation.
• It is difficult to see why anticipated inflation, being an increase in all prices at the same rate, is harmful to production, the basis of an increase in wealth.
• After all, when prices rise together, no one individual is worse off if the inflation has been perfectly anticipated.
• It is unanticipated inflation that is the problem for producers, as it has the potential to derail their profit calculations.
• However, inflation, even when fully anticipated, can harm holders of financial assets yielding fixed incomes by eroding their wealth.

Inflation control

• As the volume of financial wealth in an economy increases so does the power of its owners over government.
• Now inflation control tends to take centrestage in economic policy formulation.
• When inflation control is implemented via monetary policy it results in higher interest rates.
• Managers of financial wealth lobby for such a policy on behalf of their clients. This lobbying is the origin of the policy of inflation targeting.
• Inflation targeting by the central bank involves use of the interest rate to keep inflation under control.
• As it targets inflation it must let go of the employment objective. Though ‘flexible inflation-targeting’ is meant to take care of this objection, inflation is retained as the target and the central bank is not accountable for unemployment.
• In fact, in situations where growth, employment and inflation are jointly determined, and mostly they are, inflation-targeting via the interest rate can lower inflation only by suppressing growth.
• This is the mechanism by which inflation-targeting inevitably lowers growth.
• On the other hand it points to other means of keeping inflation low, which, as has been demonstrated for India, would take the form of checking food-price inflation.

India’s hawkish stand

• In a monumental failure of the imagination, India’s policymakers adopted inflation-targeting as the defining function of its central bank, even as the rest of the world was reassessing its credibility.
• Though the switch was effected by legislation only in 2015, a hawkish inflation stance had emerged at the RBI some two years prior to that. The real interest rate swung upward by over 5 percentage points.
• Inflation did come down, but that it continued to decline even as the real interest did not do so commensurately belies the possibility that inflation-targeting alone is responsible for it.
• Commodity prices, both of oil and domestic agricultural goods, have grown slower since. Oil prices have actually been declining in certain phases, and would surely have had a direct impact on inflation.
• But the slowing of the economy after 2016, which we are still experiencing, suggests that inflation-targeting may have had an impact on growth. This would not be surprising at all.

Financial instability

• The emergence of financial instability in India following the institution of inflation-targeting is in line with what we have seen in the Anglo-American economic area.
• In India, the virtual redefinition of the central bank’s functions appears to have encouraged the RBI to consider its work done once inflation is within target.
• Televised monetary policy statements every two months would be no more than a charade, if inflation slows for extraneous reasons, and a smokescreen, if financial stability has been compromised due to lax regulation of the financial sector.

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Prelims Questions:

Q.1) Consider the following statements about the foreign exchange market:
(1) If real exchange rate is equal to one, currencies are at purchasing power parity.
(2) Purchasing power parity is often taken as a measure of a country's international competitiveness.

Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Answer: A
Mains Questions:
Q.1) How the slowing of the economy suggests that the central bank’s stance on inflation may have impacted growth?