Certainty in monetary policy

Two big takeaways from today’s monetary policy review are the institution of a formal inflation target and a commitment to consistency in monetary policy

I found two major takeaways from RBI Governor Raghuram Rajan’s press conference this morning following the RBI policy review (where both the policy rate and the cash reserve ratio were held constant).

Firstly, Rajan used this opportunity to set for the bank a long-term inflation target. In a previous review, it had been announced that the RBI was focussed on targeting a 6% inflation rate by January 2016, and that conversations were on between the RBI and the Government regarding setting a formal inflation target.

In today’s review, Rajan took this one step further announcing that after January 2016, the RBI will set its policy rate targeting an inflation rate of 4% +/- 2%. This is extremely significant for for the first time it signifies a primarily inflation-targeting objective for the Reserve Bank of India. Over the last few months Rajan has made several attempts to explain that low and stable inflation is a necessary condition for a high and stable growth rate, and having primed us with this narrative, he has finally committed to a long-term inflation target.

The second important takeaway was the emphasis on consistency in policy. Rajan mentioned that while he is prepared to cut rates when the conditions are ripe, what he doesn’t want to do is to flip-flop on rates. This means he is likely to cut rates in this policy review only if he is confident that the requirement of having to raise rates in the next policy review is going to be low. This is extremely significant, as this kind of a direction is an implicit commitment to both savers and borrowers that they can expect the same direction for a significant amount of time, which means that they can plan better.

While some commentators might be disappointed that rates were not cut today, I think today’s policy review was extremely fruitful and some of the commitments made will have important consequences in the long run. Consistency in policy is an extremely important step, and the adoption of a formal inflation target at a time when global oil and food prices are dropping is excellent timing.

The press conference itself was quite insightful, and the way Rajan and his deputies handled the questions was extremely instructive. For example, one journalist mentioned that we’ve already hit 6% inflation which was the target for January 2016, and asked why rates weren’t cut on that account. Rajan replied that the fact that inflation is 6% today doesn’t imply that it will stay there a year later, and we need to work towards holding it there, and that the holding of rates in today’s review was a step in that direction.

India’s messed up agricultural markets

Indicat seems like a good website for data on Indian commodity prices. I came across this website when someone tweeted about tomato prices. What struck me was the wide variation in tomato prices both within markets and across markets.

Now, in terms of price variations within market, some of it can be explained by way of commodities of different grades – for example if I’ve brought bright firm and big tomatoes, I’ll expect a better price than what your small squishy tomatoes might fetch. Agricultural markets usually solve this problem by means of grading (unfortunately data of grading is not available, though the website gives data on different kinds of tomato).

The bigger reason why there is such wide price disparity within a market has to do with the auctioning process itself. For this I’ll dwell upon my limited experience of one data point in terms of a day that I spent in the potato market of the APMC yard in Yeshwantpur, Bangalore.

The issue is that the auction happens in lots, and quantities are not aggregated. Let’s say I bring in a couple of sacks of potatoes. The market makers inspect and grade them, and then proceed on an open outcry auction to auction my potatoes. The auction (increasing price English auction) quickly done, the market maker moves on to the next lot which someone else has brought. And so forth.

What this means is that potatoes that a trader can purchase is limited to the extent of the potatoes that were auctioned when he was present at the market. This process of continuous auctioning thus leads to large investments in time for the traders.

More importantly, having several small auctions rather than one big auction (where goods of similar grade are aggregated) leads to fewer buyers and sellers, and that leads to inferior price discovery. A significant portion of the bid-ask spread and uncertainty in the mandies can be eliminated by just aggregating demand and supply and having only one or two auctions for a particular commodity in a day.

In this mechanism, when I bring goods into the market, they will get graded and I will be given a receipt indicating quantity and grade. At the end of the day, there will be auctions for each “micro-commodity” (commodity of a very specific type) and based on the clearing price of the auction I an exchange my receipt for the appropriate amount. This receipt can be made negotiable – in that if I choose to not wait until the auction happens or want to lock in a price, I can simply sell the receipt outside of the market!

There is no rocket science to this mechanism. The reason it is not being implemented is because incumbent operators of the APMC (agricultural produce marketing committee) yards have a monopoly on trading commodities within their respective “areas” and thus have no incentive to improve their mechanisms. On the other hand, the current mechanisms are actually beneficial to increasing the returns to the market makers, with the producers and consumers bearing the price.

Then there is the issue of price variation across markets. While local markets might provide convenience to farmers and prevent them from traveling afar to sell their produce, it once again leads to fragmentation. For example, there is no reason that there need to be 15 tomato markets in Himachal Pradesh or 75 markets in Punjab! If we have a mandi receipt system, the problem of farmers traveling can be solved by aggregators, who can issue grade-quantity receipts to the farmers and collect and aggregate produce, and then take it to the mandi. While it is important that there is competition among mandis (so that the mandi with lowest bid-ask spread gets most of the business – which is how it happens in financial markets), we should not encourage fragmentation. And with increased competition, fragmentation will simply go away.

There has been some indication that the current union government is willing to reform the APMC Act (the first step towards it was taken by the previous NDA dispensation in 2003, but went into cold storage during 10 years of UPA rule). It is perhaps the one step that can have maximum impact on controlling inflation while at the same time giving good returns to farmers and horticulturists.

Figure 1 here shows the number of markets and quantity transacted in various states:



Figure 2 shows that the more the quantity transacted per mandi (that is, better the aggregation), the lower is the variation in price:


There is massive scope for beating down food inflation by simply increasing efficiencies and cutting down bid-ask spreads in agricultural markets. Unfortunately so far policy in this direction has been hostage to monopolists who dominate such markets. It is imperative that India opens up its agricultural markets in order to aid better price discovery of agricultural goods and consequently provide better prices for both producers and consumers.


Comparing inflation across states

Have you ever wondered which states see higher inflation in a particular period? For possibly the first time ever the government has released data on consumer price indices in various states in india via its open data platform data.gov.in (there are a lot of interesting data sets on that platform. Do check it out if you haven’t already). There is also another interesting data set on the same platform which gives the price indices of various commodities over the last ten years.

Coming back to consumer price inflation across states, let us first look at which states saw the highest and lowest Year-on-year inflation (year on year inflation is calculated by comparing prices in a particular month to the corresponding month of the previous year. This helps remove any distortions caused due to seasonality) in November 2013, the last month for which the data is available.



In November 2013, by far the highest inflation was seen in Tripura. Manipur, interestingly, is at the other end of the spectrum. Now, the problem with the above graphic is that it could be hard to search for a particular state, and see if there are any patterns to which states have higher inflation compared to others.

In order to examine if inflation varies by region, we draw a choropleth. In the below map, the more red a state has been coloured, the higher its inflation is, the greener a state is, the lower is its inflation. Middling states are coloured yellow.

Source: http://data.gov.in/dataset/state-level-consumer-price-index-ruralurban-upto-november-2013
Source: http://data.gov.in/dataset/state-level-consumer-price-index-ruralurban-upto-november-2013

Offered without further comment.

Free float and rupee volatility

Following a brief discussion on twitter with @deepakshenoy I’m wondering what’s preventing the RBI from making the rupee fully convertible. The usual argument for full convertibility is that it will make the exchange rates volatile. My argument is that exchange rates are already so volatile that the additional volatility that could stem out of a free float is marginal, and a small price to pay.

The wise men at RBI, though, might argue the precise opposite. They will claim that in terms of already high volatility they wouldn’t want to do anything that might add to volatility, however marginally. This is a constant battle I faced in my last job, of delta improvements. I would frequently argued that when something was already high, making it delta higher was not so bad. I would argue in terms of making systemic changes that would reduce drastically the already high number, rather than focusing on the deltas.

Coming back to the rupee, you can also imagine the wise men talking about some stuff about black money and hawala money and all that. The thing with making the rupee fully convertible would be that hawala would be fully legal now, and the illegal practice would cease to exist. And when something becomes legalized it comes back to the mainstream rather than remaining on the margins, and that is always a good thing.

Then you can expect some strategic affairs experts to bring some national sovereignty and national security argument there. There will be people who will talk about the increase in counterfeit money (since it’ll become easier to “smuggle” rupees into India then), and about how foreign governments might pose a threat to India’s security by manipulating the rupee (who says that threat doesn’t already exist?)!

I don’t know. I don’t find any of these anti-full-convertibility arguments compelling. If we do adopt full convertibility, though, we can at least pay Iran for the oil we get from them, and that might for all you know help tackle inflation. I don’t, however, expect the RBI to act on this.

Letting the rupee float

I’m midway through Shankar Acharya’s Op-Ed in today’s Business Standard, and I realize that along with the interest rate, the exchange rate (USD/INR) is another instrument that the RBI could possibly use in order to control money supply and the level of economic activity in India. Let me explain.

Given that mad growth in petroleum prices have been fundamental to growth in inflation, and that high petroleum prices also impact the oil marketing companies and the government negatively, and that we import most of our petroleum needs, letting the rupee rise above its current level is a mechanism of reining in “realized petroleum prices”. If we were to let the rupee rise, inflation would get tamed (due to imports becoming cheaper), the government’s fiscal deficit would come down (subsidy will be reduced), but exporters will get shoved, and that can depress economic activity in the country. So letting the rupee rise is similar to increasing interest rates.

There are people who question whether the RBI should be controlling exchange rates at all, and wonder if it would be better if it were to float freely. I’ve also taken that view on several occasions in the past, but now that I think of it, there are liquidity concerns. USD/INR, EUR/INR, GBP/INR, etc. have no way near the kind of liquidity that exchange rates between two “developed currencies” (USD/EUR or USD/JPY) have. In other words, the amount of trade that happens in USD/INR is much lower than that of say USD/JPY.

Given this lack of liquidity, if let to float fully, there is a danger that the USD/INR rates can fluctuate wildly. Higher volatility in rates means higher hedging costs for both exporters and importers, and given that our foreign trade is fairly high, a wildly fluctuating exchange rate does no good in policy formulation. From this point of view, it is important that short-term volatility in the exchange rates is curbed, and to that extent I support the RBI’s decision to intervene in the FX markets.

However, if there is a sustained pressure on either side  (say the exchange rate trades for a sustained period at the edge of the “band” that the RBI is allowing the rupee to float in), the RBI should buckle and shift their bands, and let the markets have their way. While short-term volatility is not great, distorting market signals is worse.

An analogy that comes to mind is circuit breakers in the Indian stock market. Earlier, these circuit breakers were in place for all stocks (basically, they dictate that if the stock price fluctuates by more than a certain amount in a certain time period, trading in the stock will be halted for a certain amount of time). However, recent regulations have removed these circuit breakers for stocks on which derivatives are traded, which are the more liquid stocks. The circuit breakers, however, are still in place for the less liquid stocks

It’s a similar story in the FX markets. Given that USD/INR is still not too liquid (in terms of volumes), it is important that we have circuit breakers (i.e. RBI intervention). Once it reaches a certain “critical mass” (in terms of volumes ), however, the RBI can step away and let the rupee float.

(I haven’t looked at any data while writing this. All judgments are based on my perception of how certain numbers shape up)

Getting rid of the landline

A large number of people I know have got rid of the land line phones at their homes and replaced them with a mobile phone for each member of the family. So now, there is no “home number” and each member of the family has their own personal number. And from talking to some of these people, apparently the economics work out well – an uncle I know says that the combined bill out of the five mobile phones that his family members own is far less than the bill he had to pay back when he had a land line.

Now, the reason for this reduction bill is fairly intuitive – now, one can keep track of how much each of the family members talks. Earlier, even with itemized billing it would be difficult to track who made which call and who is contributing to the inflation in telephone bills. However, now, it is possible to keep track of how much each person spends. And even if the “family fund” is willing to pay 100% of everyone’s bills, people are now wary of inflating the bills since everyone will now know who has been responsible for the inflation. And that automatically causes people to speak less.

I have a landline phone. The main reason I keep it is that it comes along with the broadband connection, which is a must for me. Apart from this, I think it is important to have a “home phone” or a “family phone” even if everyone in the house has a mobile. This is especially useful to give to relatives, etc. And last but not the least the landline phone feels good to the ear and the cheek, and is comfortable to hold in the hand – compared to a mobile phone which is likely to give you a pain in the hand and ear in case of long conversations.

However, when people are concerned about cutting cost and don’t need a broadband connection, it is intuitive to personalize people’s bills and thus get rid of the landline. In fact, I think nowadays some companies do it too, where employees are expected to make their business calls through their personal mobiles and then get it espensed from the company, rather than using the common office phone.