Wednesday, July 27, 2011

The "framing effect" and monetary policy

In its quarterly monetary policy review, the Reserve Bank of India (RBI) has raised its benchmark repo rate (the rate at which it lends money to commercial banks) by 50 basis points to 8%, its 11th successive increase since October 2009.

In the accompanying statement, the RBI expressed heightened concerns at inflationary expectations getting unleashed. It argued that inflation was a far bigger concern than any slowdown in economic growth. In simple terms, as the RBI Governor's press statement indicates, the main thrust of the interest rate decision was to "moderate inflation and anchor inflation expectations".

Given this "inflation targeting" based paradigm in central bank communication, the rate hike has expectedly raised concerns about its adverse impact on economic growth. It is argued that the increased cost of borrowing would discourage investments and slow down growth. Further, they also claim that since the inflation is driven by supply-side causes, monetary policy actions will have little impact on the final outcomes. This view is based on the valid assumption of an inflation-growth trade-off.

However, a different, "over-heating economy" paradigm based central bank communication could give a different spin to this interest rate decision. It is common knowledge, and the RBI statement reiterates this, that inflation in India is caused by supply constraints. The growth on the supply-side of the economy is simply unable to keep pace with demand growth. These constraints include infrastructure bottlenecks, slow growth in manufacturing production capacity and agriculture production etc.

In the circumstances, there are only two options - ease supply-side constraints and/or slow down demand growth. Since the former is a medium to long-term challenge, the only alternative is to cool-down the economic growth. In this context, the objective of the RBI's rate hike decision becomes one of deliberately cooling down an over-heating economy. The interest rate hike has the desired contractionary effect on the economy. In this monetary policy communication paradigm, lowering growth, and not inflation, is the direct objective. If this is the objective, then the inflation-growth trade-off loses its relevance, with the balance tipping decisively in one direction.

This debate is a classic case of what behavioural economists call "framing effect". Substantively, both "inflation targeting" and "cooling the overheating economy" based monetary policy decisions amount to the same. However, when framed in terms of the former, concerns about growth come to the fore, forcing governments into criticising the central bank. In contrast, when framed in terms of the latter, where slowing down growth is the explicit objective, the criticism of the central bank is likely to be more muted.

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