In my last post I commented on the Economist magazine’s graph showing WPI inflation and the repo rate. But the other important policy variable in recent months has been the cash reserve ratio. In the context of the period of the graph, the repo rate was raised to 7.75 percent on 31 March, 2007. The cash reserve ratio then was 6 percent. By August 4, 2007, the CRR was up to 7 percent, while the repo rate was unchanged. Now both the repo rate and the CRR are at 9 percent. So one has to remember that the CRR has been raised substantially in this tightening cycle.
Is this a good idea? Raising the CRR taxes the banking sector. It is less costly for the RBI than raising interest rates, and it avoids the exchange rate impacts of higher interest rates. But it reduces the clarity of monetary policy. In fact, in January 2002, RBI Governor YV Reddy stated plainly that, “The medium-term objective is to bring down the CRR to its statutory minimum level of 3.0% within a short period of time.”
Regarding the measure of inflation, Vineet Virmani, of IIM-Ahmedabad, addresses this issue in estimating implicit monetary policy rules for India for the period 1992-2001, i.e., what rule is implied by the actual data?. It turns out that the estimated rule is extremely sensitive to the inflation measure used. Using the headline measure of inflation, the WPI, suggests that the RBI’s ‘rule’ (as implied by the data) has been destabilizing, with a Taylor-type rule inflation coefficient of less than 1, while an alternative measure (technically, a ‘trimmed mean’) indicates a rule with much better inflation-fighting properties (inflation-term coefficients of 1.6 to 2, versus 1.5 in Taylor’s original rule). It would be nice to see an update of Virmani’s estimations.
Virmani also demonstrates what we would guess from casual empiricism: that the RBI implicitly or explicitly targets monetary aggregates and the exchange rate. All-in-all, any rule implied by the data is much more complicated than a Taylor-type rule that works only with the interest rate as the policy instrument, and targets inflation and output.