Raghuram Rajan questions his peers’ policies!

Recently the Center for Financial Studies (CFS) awarded the Deutsche Bank Prize in Financial Economics 2013 to Raghuram Rajan. He presented his recent research paper on monetary response after the crisis.

He started his keynote lecture by saying “we seem to be in a situation where we are doomed to inflate bubbles elsewhere to boost the domestic demand” to question the low interest rate, “whether ultra low interest rates are part of the solution or part of the problem”. He called central bankers as “heroes” for rescuing the world from the brink of the collapse but warned his (now) counterparts, they may not be addressed same for the second half of the crisis i.e. recovery, as growth is not as expected!

He accepted the fact that he doesn’t have answers to the questions, he is raising, but he would like ask the questions!

He goes on to question the usage of monetary policy (over targeted fiscal policy) to drive the growth with the help of ultra low interest rates. He argues retirees as well as other people (who used to spend before the crisis) may not start spending in ultra low interest regime. In fact they may start saving more because spenders are under the water of debt over burden due to the crisis and retirees may not be able to get anticipated returns in these ultra low rates. Also he mentioned about “debt fuelled demand” is highly localised by quoting different spending patterns of Las Vegas and New York.

Moving on he questioned the credibility of the central bankers’ forward guidance like keeping interest rates low either time bound or conditional (like unemployment) dependent. Since recently markets started questioning the guarantee of central banks credibility and their talk.

He talked about amount of tapering may not alter much in long term Fed’s bond holding portfolio, which in turn should not have much impact on bond stock and flow.  But in reality it is not happening as per theory.

Talking about Bank of Japan, he hoped the balancing act of raising inflation expectation not too high and not too rapidly while maintaining bond yields low so bond portfolios don’t get beaten up, BOJ will succeed.

Unintended consequences of unconventional monetary policy

He said unconventional monetary policies may be intended to take more risk from entities like insurance companies and other financial corporation’s but he is not sure about that risk taking translates into real risk taking in real economy! But unintended consequences like spill-over and capital flow to emerging markets leading to asset price boom in those countries might raise the question. Politicians in emerging markets may forego the countercyclical policies during the capital inflow phase.

Even in industrial countries, monetary policy doing too much may take away the pressure from government and politicians and their focus. Because when central bankers say monetary policy is the only game in town they become the only game in town as everybody else then willing to wait. Damned if you do and damned if you don’t!

Pointing at taper talk confusions, he said we should plan our exit when we enter into something! Because of this stress he thinks emerging markets may decide not to run current account deficit, build safe structure by building reserves, focus on export led growth.

He said we need to break the cycle of one crisis to other like Asian crisis to Industrial world crisis and back to emerging market crisis again.

He ended his presentation by saying “I think I posed more questions than answers, but that’s the state of my thinking”.

Interpretations of Raghuram Rajan's monetary policy review

Business Standard: Rajan putting house in order before tapering

Business Standard: Inflation-wary Rajan skips Fed party

The Economic Times: The buck doesn’t stop at the RBI: Lowering food inflation is the govt’s job

The Financial Express: RBI wastes Fed moment

Sajjid Chinoy of JP Morgan: Balanced and pragmatic

Niranjan Rajadhyaksha of mint: Why has Raghuram Rajan hiked the repo rate?

Tamal Bandyopadhyay of mint: Repo hike: A signal of Rajan’s lack of tolerance for inflation

Andy Mukherjee of Reuters BREAKINGVIEWS-Raghuram Rajan wants to be India's Paul Volcker

Indranil Pan of Kotak Mahindra Bank: Rajan responds to the need of the hour

Saurabh Tripathi of The Boston Consulting Group: Raghuram Rajan needs to transform RBI into a multitasking innovator

Siddhartha Roy of Tata Group: Usual prudence takes over

Expert Views in The Economic Times: RBI raises repo rate, CRR on hold

How Raghuram's rate hike is a blessing in disguise

Mayur Shetty of The Economic Times:Is Raghuram Rajan walking ex-Federal Reserve chief Paul Volcker’s talk?

Raghuram Rajan’s first step towards “Walk the talk”

Reserve bank of India governor Raghuram Rajan surprised financial markets on Friday in his first monetary policy review by increasing repo rate. Repo rate is interest rate at which RBI lends to banks.

Financial markets took knock as they weren't prepared for rate hike since economy is growing at slowest pace in recent time, manufacturing/industrial production is almost at standstill and some parts of interest rates were already jacked up to defend the Rupee.

But defying expectations, he decided to,

1) Increase repo rate by 25 basis points from 7.25% to 7.5%

2) Reduce the marginal standing facility (MSF) rate by 75 basis points from 10.25% to 9.5%

3) Reduce the minimum daily maintenance of the cash reserve ratio (CRR) from 99% of the requirement to 95%

On his first day as the Governor of Reserve Bank of India Raghuram Rajan said, “The Governorship of the Central Bank is not meant to win one votes or Facebook “likes”. But I hope to do the right thing, no matter what the criticism, even while looking to learn from the criticism. Some of the actions I take will not be popular.” Guess he was giving signal to markets that he is not here to please, but do the right thing!

By taking these steps he

1) Set his priority of “anchoring inflation and inflation expectations”. He thinks in the absence of an appropriate policy response, WPI inflation will be higher than initially projected and CPI inflation is worrisome. He wants to be ahead of the curve to achieve his target instead chasing it after it goes beyond control. But that doesn't mean he will sacrifice growth to have disinflationary pressure. He believes low and stable inflation in turn boost savings and investor confidence in the economy. He said in concluding remark, “the Reserve Bank will closely and continuously monitor the evolving growth-inflation dynamics with a readiness to act pre-emptively, as necessary”. Here we should remember his first day’s “A central bank should never say “Never”!” remark.

2) & 3) Is reversing some of the steps, which RBI had taken to fight the Rupee depreciation and volatility. These will take care of liquidity pressure in the banking system, additional cost of funding and send out the message loud and clear that normalizing monetary policy operation. Going ahead once the reverse repo-repo-MSF corridor come to normalcy (100 basis points difference between each), repo rate will resume the operational policy rate role.

After watching his media address (following policy review) and listening to teleconference with researchers and analysts, one thing he made sure that he is here for change. Same thing he conveyed on the 4^th September, “It involves considerable change, and change is risky. But as India develops, not changing is even riskier.”

Repeatedly he clarified things like Urjit Patel and team working on an inflation model to target instead of either plain WPI or CPI. Unusual but unique, Rajan is trying to do the balancing act between inflation anchoring, easing liquidity measures and bringing back the normal monetary operation procedure.

Now there are pitfalls in his walk. Being election year will finance minister allow him to take his own decisions and if yes how long? Rajan needs to take Chidambaram and Prime Minister Manmohan Singh into confidence. How long will he be able resist the temptation of growth friendly policy than targeting inflation? Will he able to balance between 3 legs of the impossible trinity in worst case? Will he be transparent in communicating policy guidance, without surprising too many times?  

Bond markets dictate Fed policy!

U.S. Federal Reserve chairman Ben Bernanke in his press conference after FOMC meeting on September 18 said “we can't let market expectations dictate our policy actions”, when asked about Fed tapering. But Federal Reserve did exactly let bond markets to dictate or reverse their policy guidance communication.

From last 4 months Fed wanted to prepare markets for the reduction in bond buying program. Various governors irrespective of their dovish or hawkish stance, they talked about either for or against tapering of bond buying. They communicated and convinced markets that Fed is expected to announce tapering of the bond buying in September meeting by $10 billion as per overall consensus in the markets.

When Fed started talking about tapering Benchmark bond yield started soaring and reached peak of 2.9% recently. Before tapering news hit the markets, Benchmark 10 year bond yields were around 1.6% in early May of this year. They jumped 130 basis points as heavy sell off in treasuries incurred. 30 year U.S. mortgage rates jumped to 4.2% from 2.8% around 50% jump! Markets started filtering in the news of Fed tapering.

After yesterday's FOMC meeting, in its press release, Fed said, “The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.” In last 4 FOMC statements, Fed used almost same language “the committee sees the downside risk to the outlook of the economy”. Where as in this meeting it talked about concerns over financial tightening conditions in recent months!

In fact recent surge in bond yields is caused by Bernanke and his colleagues’ talk of tapering. They communicated their policy guidance as usually all central banks try to maintain the transparency in their policy guidance communication and their thought process.

Actually short term money markets eased in this span of 4-5 months. Below is the table in which all indicators indicate short term borrowing rates eased in all category.

Money market indicator	May 1, 2013	September 17, 2013	Change
2 week repo	0.17%	0.08%	-52%
3 month repo	0.16%	0.08%	-50%
2 week mortgage repo	0.21%	0.10%	-52%
3 month mortgage repo	0.20%	0.13%	-35%
Fed fund rate	0.15%	0.09%	-40%

Here question is not about whether economy started recovering or started creating enough jobs; it’s about how the world’s biggest central bank failed in judging economic scenario and failed in their communication. Many referred it as “surprise”, I would like to call it call as shocking. Surprises can be like Paul Volcker doubling Fed fund rates from 10% to 20% between 1979 and 1981 to tame the inflation. But not this one, where Fed prepared the markets for tapering and in turn markets convinced Fed not to taper!

Bernanke may be worried about Greenspan legacy!

According to various polls and forecasts U.S. Federal Reserve Chairman Ben Bernanke is expected to announce scaling back the monetary stimulus in the FOMC meeting (17th &18^th September). As per consensus Fed is expected to cut down its monthly bond buying program by $10 billion from present $85 billion (Fed is buying $45 billion government bonds and $40 billion mortgage securities per month to stimulate the economy).

When Bernanke spoke about tapering down of bond buying program first time in May, 2013 global markets reacted very sharply. U.S. bond yields soared, emerging countries’ bond, stock and currency markets sold off heavily and some counties' (Brazil and Indonesia) Central banks raised interest rates to prevent outflow. Aftermath of the global markets volatility, analysts started discussing timing and quantity of Fed tapering, whether American economy produced enough employment, whether economy recovered from the crisis, if yes then is this recovery sustainable?

But Bernanke may not be worried about timing (September or December) of tapering or quantity of tapering but the way markets are expecting and perceiving the quantitative easing (QE)! He may be worried about QE boosting asset prices than real economy going ahead. He may be worried about market expectations of low interest rate for too long. He may be worried about continuing his policies in his name after his exit from Fed Chair in January 2014. He may be worried about how history is going to see him, the one who saved the world from the great recession or the one who lead the world from the great recession to one more crisis!

Alan Greenspan, Bernanke’s predecessor lowered American interest rates after dot com bubble burst and 9/11 attack. Analysts criticise him for leaving interest rates too low for too long time, which was one of the reason for housing boom during early 2000. By the time Greenspan left Fed Chair (January 2006) American economy was at the edge of new crisis. Housing prices skyrocketed and it was too late for regulation and monitoring the situation as complex derivatives products dragged investments banks, insurance companies, banks, broking firms and rating agencies into the sector leading to economic crisis. So critics say Greenspan lead America from one crisis to another crisis!

Bernanke, whose term is ending in January 2014, may not want to repeat the Greenspan legacy! He may want to communicate to markets that stimulus shouldn't be taken for granted. He may be suggesting real economy benefitted sufficiently from quantitative easing or monetary stimulus has reached its limits to boost the economy and beyond this there might be bubble formation! He may want to leave the office with a note to historians stating that he started it (QEs) but he also tried to end it!

Raghuram Rajan: Governorship is not meant to win votes or Facebook “likes”!

Yesterday, 4^th September, Raghuram Rajan took the charge of Reserve Bank of India (RBI) governor’s role from outgoing D. Subbarao.  He started his first day with a bang, effectively communicating his priorities, by this he has taken care of recent criticism faced by RBI of not communicating clearly!

To begin with, he acknowledges the fact that “the economy faces challenges” and “these are not easy times” and at the same time he tried to calm the nerves by saying “India is a fundamentally sound economy with a bright future”.

Never say “Never”!

Rajan said “A central bank should never say “Never”!” meaning RBI is ready to take all possible options available on the table. Also he made it clear that RBI should emphasise on “transparency and predictability”. In these volatility times he wants “RBI should be a beacon of stability as to its objectives” so that markets should know what central banker is doing where it is going.

Monetary Policy

As reported earlier, RBI postponed previously set meeting on 18^th September to 20^th September. Rajan said he postponed it to “have enough time to consider all major developments in the required detail”,  indirectly he is saying he wants to take calculated move after watching policy guidance from United States Federal Reserve meeting scheduled on September 17-18.

He talked about “monetary stability” (different from “price stability”) to emphasize confidence in the Rupee. This is a welcome change in the RBI’s usual language of “price stability” and also “monetary stability” takes care of value of currency, inflation and source of inflation.

Inclusive Development

Rajan said “the RBI will shortly issue the necessary circular to completely free bank branching for domestic scheduled commercial banks in every part of the country. No longer will a well-run scheduled domestic commercial bank have to approach the RBI for permission to open a branch” to give importance to rural banking and small and medium scale industries’ funding.

He said Dr. Bimal Jalan will head a committee to screen the licence applications for new banking licences and hope to announce the licences within, or soon after January 2014. Further he said going ahead RBI will simplify the process of banking licences and banking domain entry.

He stressed about reduction of banks investment in government securities in a calibrated way, which will improve banks productivity and competitiveness.

He talked about foreign banks and their expansion plans but with certain regulations, so that RBI is not blindsided by international developments.

Financial Markets

Rajan talked about liberalising financial markets and restrictions on investment and position taking. So that investors take positions domestically and provide depth and profits to our economy than they take our markets to foreign shores.

He talked about increasing the permitted value of re-booking of cancelled forward exchange contracts for exporters and importers, developing domestic money markets and government securities and introducing interest rate futures on overnight interest rates.

Rupee internationalization and Capital Inflows

In Rajan’s words, “this might be a strange time to talk about rupee internationalization, but we have to think beyond the next few months. As our trade expands, we will push for more settlement in rupees. This will also mean that we will have to open up our financial markets more for those who receive rupees to invest it back in. We intend to continue the path of steady liberalisation. The RBI wants to help our banks bring in safe money to fund our current account deficit”.

Financial Infrastructure

To improve the reach, speed of flows as well as quality and quantity of lending he said strong financial infrastructure is need of the hour. He talked about using Adhaar, and information sharing between credit bureaus and rating agencies.

He talked about the cleaning up of banks balance sheets, bad loan problems and capital raising programs, which might face difficulties in a decelerating growth rate. He pressed for recovering loans, improving of the recovery system and related institutions.

Households

He announced Inflation Indexed Savings Certificates linked to the CPI New Index, to protect the households against CPI inflation. He said electronic bill payment system through bank accounts to “make payments anywhere anytime a reality” and mobile based payment, which can be a revolution if implemented successfully. RBI will facilitate for mini ATMs by non-bank entities.

In conclusion he said, “It involves considerable change, and change is risky. But as India develops, not changing is even riskier. Some of the actions I take will not be popular. The Governorship of the Central Bank is not meant to win one votes or Facebook “likes”. But I hope to do the right thing, no matter what the criticism, even while looking to learn from the criticism”.

Indian equity markets and rupee welcomed Rajan with a rally and brokerages have increased their target levels. Rajan started with a bang, but walking the talk is important now and his path (read my earlier post: Raghuram Rajan’s Trilemma) is not easy.