The popular belief about the tussle between RBI and the Ministry of Finance is that it is an issue of the trade-off between inflation and economic growth, with the former more focussed on controlling high inflation and the latter emphasising high growth. However, according to Gurbachan Singh, there is a different dimension to the story; the Ministry doesn't fully appreciate that RBI cannot ignore market forces while making announcements about interest rates.

There has been a tussle between the Ministry of Finance (MoF) and the Reserve Bank of India (RBI) in the last three years, since Dr. Raghuram Rajan has been the Governor of the RBI. It is about the level at which the RBI should set the repo rate¹. (Contrary to what many believe, the RBI is not an independent central bank; according to the Constitution, the Government of India controls the RBI) The recently released book by former RBI Governor Dr. Subbarao now confirms that there had been a similar tussle during his five-year term (2008-2013) as well. The usual view on such a tussle is that it is an issue of the trade-off between high inflation and high economic growth²; the MoF emphasises high growth whereas the RBI is more focussed on controlling high inflation. However, there is a very different dimension to the story.

Interest rates: Conventional wisdom and new thinking

Very briefly, the usual view is that the central bank sets the short-term interest rate (the repo rate in India and the federal funds rate in the US); the economy then somehow adjusts³, sooner or later, to the dictated short-term interest rate. This may seem straightforward and even obvious. However, Nobel Laureate Eugene Fama has challenged this view (Fama 2013). He argues that the Federal Reserve System (Fed) has little power to set, what is commonly known as, the 'federal funds rate'! He uses empirical evidence for the US to show that the Fed has hardly any power to determine the short-term interest rate – notwithstanding all the noise about how the Fed decides that rate every now and then. It is hard to dismiss that view, given the facts⁴.

Let us elaborate a little more on the situation in the US. The common view is that the interest rates are generally low in the US at present because the Fed has dictated a low federal funds rate. The alternative view is that it is low because that is the market outcome; at the end of the day the Fed simply goes along with the market level of interest rate. The market interest rates in the US are, in turn, generally low possibly because savings increased and investment fell⁵ in the aftermath of the global financial crisis and the recession in and around 2008⁶.

Cuts in interest rates by the central bank are sometimes not followed by cuts in lending rates charged by commercial banks and other financial intermediaries. Why? The usual view is that the transmission mechanism is weak (see, for example, Mishra et al. 2016). However, there is, in my view, another possibility. The rate cuts by central banks in some countries may not be in sync with the market forces in which case the financial institutions will not - nay - cannot apply rate cuts! The central bank can then, at times, have a good rationale not to reduce its interest rate to begin with.

RBI cannot ignore market forces

With all this background, let us come to the specific case of India now. In what follows, I will argue that even if Fama (2013) is not applicable to India and even if there is no difficulty with regard to the transmission of the monetary policy, there is still a broad and general lesson from Fama (2013), which is that the RBI cannot ignore market forces. It is this premise that is not well appreciated in the MoF.

Dr. Subbarao faced the challenge that the inflation rate in India had crossed 10%. Under the circumstances, it was hardly possible for the RBI to decide on a low repo rate. If it had lowered the repo rate, it could have raised expectations in the market of higher and somewhat sustained inflation⁷. That would have led to an increase, and not a decrease, in the nominal interest rates generally in the market (Friedman 1968). (Nominal interest rate is equal to real interest rate plus expected inflation.) Also, as the inflation rate keeps getting higher, there is a serious risk that the growth rate in the economy would fall⁸. So, anticipating all this, it was hardly possible for the RBI to reduce its repo rate.

The inflation rate had somewhat eased during Dr. Rajan's term. So there was, on this account, scope for the RBI to reduce its repo rate. However, there was another issue. Dr. Rajan had to oversee the transition of the Indian economy from the long-term average inflation rate of around 7% to the targeted inflation rate of 4% under the new inflation targeting regime. This requires a decrease in the long-term growth rate of reserve money⁹ (Table 1). This shows that the average rate of growth of reserve money in the recent time is less as compared to the average for the previous years. With tight monetary conditions till the economy stabilises at the 4% targeted inflation rate in the next 1-2 years, obviously the general market interest rate would be high – not due to very high inflation but due to the tight monetary conditions in the transition period. Under these circumstances, it is hardly feasible for the RBI to fix a low repo rate.

Table 1. Growth rate of reserve money (%), 2001-02 – 2014-15

Data source: Table 46, Average monetary aggregates, date: September 16, 2015, Handbook of Statistics on Indian Economy.

Contrary to conventional wisdom, the tussle between the RBI and the MoF can be about adjusting to new situations and new ideas (the MoF is often lagging behind in this matter possibly because its comparative advantage lies in fiscal policy and not in monetary policy). Also, it needs to be realised that the powers of the RBI are less than what these are widely believed to be; the market forces cannot be ignored.

Notes:

1. Repo rate in this context is the rate at which the RBI lends money to commercial banks.
2. Low interest rates can encourage investment, which can increase growth in the economy. On the other hand, low interest rates go alongside more liquidity in the economy, which can be inflationary. So, low interest rates may promote higher growth but at the cost of higher inflation.
3. Suppose that the economy is in equilibrium to begin with. Then the interest rate is changed. With this, the economy moves to possibly another equilibrium. This movement is referred to as adjustment here. In the process, there can be effects on savings, investment, asset prices, banks' balance sheets, exchange rate, and so on. These can in turn affect other variables
4. Fama (2013) cannot be dismissed for another reason. Suppose the conventional wisdom is correct and the Fed can indeed fix the interest rate as it chooses to. This raises a different set of issues. These are, however, outside the scope of this column. The interested reader can see Singh (2015).
5. Savings are positively related to interest rate and investment is negatively related to the interest rate. The equilibrium interest rate is where savings are equal to investment. Savings and investment depend also on factors other than the interest rate. If due to these other factors, savings rise and/or investment falls, then the equilibrium interest rate falls. However, it cannot fall beyond a point - say, zero. Then, the adjustment is through a fall in income as a result of which savings fall, and market equilibrium is attained at the floor level of the interest rate.
6. Personal (household/individual) savings rate in the US has increased from less than 3% before 2008 to more than 5% in 2016. Also, the retained corporate earnings (part of corporate earnings that are invested in the corporation rather than being paid out to shareholders) have increased substantially. Investment fell from more than 23% of GDP (Gross Domestic product) to less than 18% in the aftermath of the recession in and around 2008; it is still far from full recovery.
7. There are two channels by which interest rates influence inflation: First, lower rates are consistent with higher liquidity, which can increase inflation. This can, in turn, raise the expected inflation rate in the future. Second, the public associates low interest rates with high inflation; hence, lower interest rates can lead to expectation of higher inflation.
8. When the inflation rate is somewhat low, there may be a 'static' trade-off between higher inflation and higher output (level or growth) in the short run. However, when the inflation rate is somewhat high, there is hardly any trade-off; instead, we can get high inflation and less output (level or growth).
9. Reserve Money is the sum total of the currency in circulation in the economy, along with bankers' deposits and 'other deposits' with the RBI.

Further Reading

• Fama, F Eugene (2013), "Does the Fed control interest rates?", The Review of Asset Pricing Studies, 3(2):180-199. Available here.
• Friedman, Milton (1968), "The role of monetary policy", The American Economic Review, LVIII (1):1-17. Available here.
• Mishra, P, P Montiel and R Sengupta (2016), 'Monetary Transmission in Developing Countries: Evidence from India', Working Paper, Indira Gandhi Institute of Development Research.
• Rajan, R (2016), 'The fight against inflation: a measure of our institutional development', Speech at the Tata Institute of Fundamental Research, Mumbai, 20 June. Available here.
• Singh, Gurbachan (2015), "Thinking afresh about central bank's interest rate policy", Journal of Financial Economic Policy, 7(3): 221-32.
• Subbarao, D (2016), Who Moved My Interest Rate? Leading the Reserve Bank of India Through Five Turbulent Years, Penguin Books.