Reddy vs Greenspan

RBI Governor Y.V. Reddy has raised the cash reserve ratio (CRR) — the amount banks hold with the RBI — in an attempt to reduce bank lending. A reduction in bank lending will reduce bank deposits and hence money supply, which consists of currency and bank deposits. It is expected to reduce the upward pressure on prices which arises from higher demand in the economy. It is, therefore, an anti-inflationary measure taken to offset the impact of the expansionary monetary policy followed in the last two years. At the same time, Reddy has reduced the rate which the RBI pays to banks for their balances held as CRR from 6 per cent to 3.5 per cent. This will protect the balance sheet of the RBI, which will now pay a lower interest on the larger balances that banks will now hold with the RBI. The move to tamper with the CRR, an implicit tax on banking, rather than the direct instrument of interest rates, is not consistent with the RBI’s medium-term policy of moving towards a 3 per cent CRR. The RBI has given no clear indication that it will or will not raise interest rates.

This is in complete contrast to what is happening internationally. When Alan Greenspan, chairman of America’s Federal Reserve Board, felt that inflation in the US was rising, he shared his views with the country. For many months, in many speeches, he said that he would raise interest rates. For months observers watched and waited, hanging on to every word he uttered. The question became “when” and not “if”. The economy was well prepared for the fed rate hike when it came. It was a small hike, followed by more speeches by Greenspan about raising rates. The story is still playing out in the same fashion. The most important element of Greenspan’s strategy is managing expectations. The reduction in interest rates over the last few years was implemented in a similar fashion. Now he is following the same strategy, cushioning the economy from shocks as much as possible.

In contrast, the RBI governor is still giving no clear signals about raising interest rates. If he believes that inflation has to be addressed by tight money policies, he should say so and prepare the country for it. Households taking floating home loans should know what to expect. Firms making investment decisions should factor in his plans. Reddy should learn how to conduct monetary policy from the Bank of England which puts up the discussion of the Monetary Policy Committee on its website in a move towards transparency and openness.