Raghuram Rajan is India’s new central banker. God help him.

August 7, 2013
Raghuram Rajan, the new head of the Reserve Bank of India. (UChicago)
Raghuram Rajan, the new head of the Reserve Bank of India. (UChicago)

Raghuram Rajan is the new leader of India's central bank, the Reserve Bank of India. The respected University of Chicago economist will thus be guiding monetary policy for the world's second most populous nation. He faces a seemingly impossible task: To rein in the nation's double-digit inflation without excessively crimping India's growth, which has already slowed.

So who is Rajan, and what are the challenges he will face in trying to drive higher incomes and more stable prices for 1.2 billion Indians?

Before his current appointment to lead a major central bank, Rajan was perhaps best known for getting dissed by Larry Summers. The occasion was the 2005 Jackson Hole conference, the annual central bankers' retreat in Wyoming organized by the Kansas City Fed. With Fed chair Alan Greenspan set to leave early the following year, the event functioned as a de facto celebration of Greenspan's 18-year tenure.

Rajan came to rain on the parade and argue that the previous decades of financial innovation could end up backfiring and causing a financial crisis. In a paper entitled, "Has Financial Development Made the World Riskier?" he answered in the affirmative. Changes in the financial system had "expose[d] the system to large systemic shocks" from sudden changes in the prices of assets (like, say, mortgage-backed securities), increasing the probability of a "catastrophic meltdown".

Of course, that's exactly what ended up happening, giving Rajan a Cassandra-like reputation after the crash, but at the time, Summers wasn't having it. In a discussion at Jackson Hole, he said he "finds the basic, slightly Luddite premise of this paper to be largely misguided." Donald Kohn, who would soon become Vice Chair of the Federal Reserve board, also had his doubts. In a paper responding to Rajan, Kohn argued that policies to stem risk-taking would, "result in less accurate asset pricing, reduce public welfare on balance, and definitely be at odds with the tradition of policy excellence of the person [Greenspan] whose era we are examining at this conference."

Eight years later, odds are fairly high that either Summers or Kohn will be the next chairman of the Federal Reserve (Janet Yellen is the other leading candidate). Whoever gets the post, Rajan will be a colleague in the close-knit club of leading global central bankers.

The inflation, it's alive!

If your sole criterion in selecting a central banker is "ability to predict major financial crises," it's hard to beat Rajan. Fans of monetary stimulus may be more skeptical. He's expressed doubts that juicing demand through either monetary and fiscal mechanisms would do much good for the United States, and has been skeptical of quantitative easing in particular.

But the challenges that the Reserve Bank of India faces could hardly be more different from the concerns of the Fed. Even the 2007-8 crisis wasn't able to stop the country from growing:


Indeed, the most recent real GDP data showed 4.8 percent year-over-real growth, which was considered bad compared to recent trends. A declining rate of growth is a real challenge, but it's a very different challenge from the one confronting U.S. policymakers, who have to deal with a massive output gap that isn't close to being closed.

What's more, Indian policymakers have a lot more room to maneuver. The repo rate in India — the rate the Reserve Bank of India (RBI) lends to banks at — is 7.25 percent. By contrast, the U.S., British and European central banks have policy rates that are about as close to 0 as you can get. We're at what economists call the "zero lower bound." We can't really cut interest rates below where they are now, which means we have to use exotic tools like quantitative easing to loosen monetary policy further. The RBI, by comparison, has 7.25 points worth of room to loosen monetary policy. There's a lot it can do with the normal tools.

But the biggest difference is that while the U.S. and Europe don't have any inflation to speak of at the moment, India has a major inflation problem. The Wholesale Price Index — the main inflation measure for Indian policymakers, which looks at the prices that businesses charge each other — edged up to 4.86 percent in June:


That's below the 5 percent medium-term inflation target that Rajan has endorsed and that current RBI leader Duvvuri Subbarao has been aiming at, but it's well above the long-term target of 3 percent that Subbarao set. More importantly, though, consumer prices are rising much faster than producer prices. In June, the consumer price index (the Indian analogue to the U.S. CPI) rose 11.06 percent, and food inflation was 14.86 percent.

A related challenge is that the rupee has been falling relative to other major currencies of late. In some cases, that's desirable as a way to goose exports, but the conventional wisdom is that this effect is outweighed by the upward pressure it puts on inflation by making imports more expensive, not to mention its effect of increasing the cost of loans in other currencies for Indian businesses.

What to do about it?

Some observers think all that means that India should be tightening its monetary policy. Some tentative moves were made in that direction last month in an attempt to bolster the rupee, but that followed three consecutive rate cuts since January. The result is that rates are below what a Taylor rule — perhaps the most popular formula for determining a central bank interest rate given the state of economic growth and inflation — would recommend, as this chart from Ahmed Raza Khan at the Indian business publication Mint shows:


Arvind Subramanian, an economist at the Peterson Institute and the Center for Global Development, thinks it's tricky to use the Taylor rule in the Indian context, just because measuring output gaps is so tough in developing economies like India. But he agrees that a tighter policy is called for, to fight inflation and strengthen the rupee. "You would expect real interest rates to be 2-3 percent, if not more," he says. "We've not been close to that for some time."

But raising interest rates to get to that point is going to be politically tricky. "In India, it used to be an iron law of political economy that if inflation went above 5 percent, people would be up at arms," Subramanian explains. "The puzzle is that inflation has remained at around 10 percent and there hasn't been an outcry." The corollary there is that if people are comfortable with 10 percent consumer price inflation, then the kind of interest rate hikes necessary to bring it down to 5 percent probably won't go over too well, especially if tighter policy makes already relatively weak growth still weaker.

By law, India's central bank doesn't have much political independence, as Rajan serves at the pleasure of the government and can be sacked at any time. That could deter him from making tough moves against inflation that could have unpopular implications for growth. But Subramanian thinks he'll have a great deal of flexibility in practice, even if the opposition Bharatiya Janata Party comes to power again. "In practice over time a central bank governor has wielded a measure of independence because people think it's a very important job and previous incumbents have been reasonably good," he explains.

Rajan better hope so. The monetary situation is such that he may be forced to act as India's Paul Volcker, hiking up rates and perhaps even orchestrating a recession to get the currency and inflation under control. He's said as much recently, arguing that supply-side adjustments, spurred along by tight monetary policy, are necessary if the country's going to grow quickly in the medium-term. But similar policies earned Volcker the enmity of homebuilders (who sent him two-by-four slabs of wood in protest) and others suffering from high rates, but at least the formal independence of the Fed helped him stay in his job. Rajan might not be so lucky.

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