Sargent, Sims and RBI Financial Express, 12th October 2011

It has become almost a fashion that the Nobel Prize winners get their reward long after they have made their contribution. It is said in a wry manner that seldom do the winners actually get to enjoy this recognition in their prime and end up ruminating over the same in their twilight years. Also, some of the winners become famous after the award while being in the shadow for most of their careers. However, the field of economics has been different, as it does recognise economists in their prime and for very relevant reasons. This holds especially for Thomas Sargent and Christopher Sims, who are just too relevant in this uncertain world of financial and country crises. Their theories have added method to the madness around us, thus signalling to policymakers as to what should be done.

Their relevance today is for all central banks and governments as they seem to be quite unsure of what should be done given the low level of credibility in a situation of economic downturn. How do we go around framing policies when there is a two-way symbiotic relation between economic variables and policies? For example, central banks base their policies on what they expect economic agents to do, while these agents base their decisions on the basis of what they expect the central bank to do. Therefore, every step taken in this game is based on expectations of the behaviour of the other. One is not sure of whether one or both will get it right. How then does one reach equilibrium, considering that each of the participants is one step ahead of the other all the time?

This is where Thomas Sargent took off on the efficacy of policy changes that are expected and unexpected in the now famous theory of Rational Expectations, along with Robert Lucas, way back in the 1970s. Let us suppose that all of us now expect RBI to increase interest rates later this month. We, as rational economic beings, adjust our decisions based on this rate hike. Now when this rate hike takes place, we see that it is ineffective as it no longer matters as decisions have already factored in these changes. Therefore, Sargent would say that for policy to have its effect, it must be unexpected. In simple language, this means that RBI should, say, raise rates by 50 bps instead of an expected 25 bps if the market is expecting the latter. Intuitively, we can see that when we expect a 25 bps increase in interest rates, we may increase our demand for credit beforehand and hence dent RBI’s move when it happens, which is aimed at controlling growth in credit.

The same holds for tax policies of the government. Sims talks of shocks while Sargent stresses on systemic policy shifts that matter. Both ways, there is a challenge for policymakers, especially when they target, say, inflation. Should we lower tax rates? The crude oil customs rate was lowered by the government around three months ago, but that did not help as prices continued to be rigid. Similarly, RBI has increased interest rates to curb inflation, but the impact has not been satisfactory and this is where we have another theory of efficient markets that comes in the way. If markets are efficient, then they take into account all factors that move it automatically so that the price discovered imbibes the same, which, in the context of expected policy responses, is already subsumed. Therefore, we do need systemic policies to counter the same and not just single shots at rate hikes. Maybe this is what RBI has been pursuing for the last 18 months or so with sustained increases in rates.

The quandary for policymakers is quite interesting. By raising rates, we can impact inflation with a lag of two years (based on their studies). However, the impact on GDP is immediate, as spending stops immediately and hence this is the starting point of the problems as it takes a substantially longer time period for this reversal to upswing.

But the question for, say, RBI, or even the Fed, is whether or not the market is really efficient. If it is, in the theoretical sense, then it may not matter. But in the current context, where there is asymmetric information and varied expectations based on numerous conjectures, an optimal solution will still not be forthcoming, thus opening up the scope for systemic policy steps, which, though not unexpected, are still effective.

These economists have used a lot of econometric modelling to prove their theories and, given the nebulous and symbiotic relation between the two sets of factors, RBI should probably build a strong theoretical basis for its policy actions based on empirical evidence. This will explain, if not resolve, the ongoing debate of the tenuous relationship between interest rates and inflation, where the majority view is gravitating towards the school that given the lags involved, we may just about be shooting in the dark.

Also, to address the issue of providing shock therapy to the markets to be more effective, maybe there should be no official communication on the central bank’s view of interest rates as we have an official statement coming in every 45 days. This may just make the statements more powerful in terms of effect, which is what monetary policy is all about.

Therefore, a combination of systemic policies with shock elements could be the prescription.