Why there was a conflict between rbi governor and finance minister of india due to the lending rates of banks?
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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.
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.
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