The Fed versus the RBI

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani

The central banks of the world's largest economy and the world's largest democracy could not be more at odds in their approach to dealing with economic problems. Just recently, the Fed announced that extremely low rates would remain in place until the end of 2014, in order to strengthen economic recovery in US.

Throughout the last few years, the Fed has maintained an extremely loose monetary policy. This includes lowering interest rates to near zero, two rounds of quantitative easing, yield curve operations, and the promise of further easing to come. This type of behavior is unprecedented for the US economy, as interest rates have never been so low for such a long period of time.

The Reserve Bank of India (RBI) has maintained an extremely tight monetary policy over the last two years. Interest rates have steadily risen in order to combat inflation, and only recently have rates stopped going up. The most recent inflation data has been lower than the past, but still remains at levels that are too high.

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One consequence of the tight monetary policy has been slowing growth rates. The RBI has recently indicated its concern over growth, and may reverse its tight monetary policy in the future. Nonetheless, their focus is and remains inflation first, and growth second.

On the one hand, we have the Fed, whose policies are primarily driven by growth and employment figures, at the expense of inflation. On the other hand, we have the RBI, whose policies are primarily driven by inflation, at the expense of growth. So which approach is the best?

The answer depends on which sector of the economy we are concerned with. In a tight monetary policy environment with high interest rates, business investment suffers, and consumer access to credit suffers. On the other hand, savers benefit due to high interest rates, and most of the population benefits due to lower inflation.

In contrast, a loose monetary policy has the opposite effects. Businesses benefit as they can borrow more cheaply and debtors benefit as they pay lower rates. Savers suffer due to receiving low interest rates, and those on fixed incomes suffer from higher inflation.

If we are looking at the economy as a whole, things once again depend on what is more important. Is it better to have higher growth at the expense of higher inflation, or is it better to have lower inflation at the expense of lower growth? Both the RBI and the Fed have differing views on this last question, and this forms the basis of their policies.

In general, having a balance is a good thing. Both the Fed and the RBI have monetary policy stances that are too extreme. A balanced monetary policy should place importance on both growth and inflation, as both statistics are vital to the well functioning of any economy.