Macroeconomic challenges and appropriate monetary policy mechanisms to tackle the same in the context of global integration of Indian economy.

Abstract

In his Key Note Address at the Conference on China's and India's Changing Economic Structures: Domestic and Regional Implications, organized by the IMF, the China Society of Finance and Banking and the Stanford Center for International Development in Beijing during October 27-28,2005, Dr. Rakesh Mohan talks about 6key puzzles for the contemporary monetary policy. These are, (1) the US dollar appreciating despite increasing US twin deficits, (2) soaring oil prices accompanied by strong global growth, (3) long term bond yields falling in the presence of FedFund rate hikes, (4) low consumer inflation in the presence of abundant liquidity and increasing asset prices, (5) strong global growth accompanied by slowdown in global saving and investment rates and (6) the phenomenon of low inflation despite currency depreciation. In his opinion these 6 issues go against the conventional wisdom of monetary policy and the monetary tools and techniques in vogue do not seem to be able to effectively address the challenges. As he points out, despite the twin deficits (CAD and FD) in the US and the steadily rising oil prices, both the short-term interest rates as well as inflation were benign. While he espouses many reasons for the above phenomena, three factors seem to hold the key. First, due to increased transparency and the structural changes brought about in the functioning of central banks, the decision making process has become more effective. This has in turn resulted in increasing the credibility of the central banks and hence has removed the 'decision shocks' and the concomitant inflation expectation associated with such shocks. Second reason for low inflation is the focus of various governments in the last ten years on prudent fiscal management and containment of fiscal deficits. Along with this, countries have signed multilateral agreements that focus on quantitative, verifiable measures of fiscal prudence. Moreover some countries like India have brought in legislation that targets fiscal deficits. Reduction / stability in fiscal deficit have enabled stable inflation levels. As regards to hike in Oil prices, Dr. Mohan points out that unlike the previous oil price hikes which were supply driven, the current oil price hike is driven by secular increase in demand from the global growth. Moreover the money raised from oil is being pumped back into the global economy through direct and portfolio investments leading to further growth. Dr. Mohan also touches upon other reasons like increase in productivity, broadening and deepening of financial markets, increasing share of non-trade ables in the GOP, global flow of material and labour and substitution of ideas over physical matter in the creation of economic value as some additional reasons for the existence of the six puzzles mentioned above. Given that savings and investment rates are declining along with higher growth rate and oil prices are steadily rising, Dr. Mohan anticipates a sharp correction in the short to medium-term. He recommends a two fold strategy to contain the impact of the correction vis. consumption needs to give way smoothly to investment with the withdrawal of policy accommodation in industrial countries, and the locus of domestic demand needs to shift from countries running deficits to ones with surpluses so as to reduce the current account imbalances. He feels that the central bankers may need to need to return to more quantity based instruments, either through micro actions by central banks or structural actions by the fiscal authorities. Central banks would perhaps have to again resort to activating more detailed prudential, regulatory and supervisory roles aimed at disciplining different segments of the financial markets. Similarly, if external imbalances are perceived to arise because of fiscal imbalances, they will have to be attacked directly, rather than through increasingly ineffective exchange rate signals. In this context our paper attempts to analyze Macroeconomic challenges facing the Indian Economy in the changing global scenario (with oil prices touching new highs every day), Policy options available to the authorities to tackle the challenges and suggest an appropriate framework to make the correct choices keeping in mind the three imperatives of monetary policy: Maintain price level, reduce volatility in exchange rate, and ensuring stable money supply growth.