Raghuram Rajan reacts during an interview with Bloomberg Television in Davos, Switzerland. (Photographer: Simon Dawson/Bloomberg)

Raghuram Rajan Bats For Steady Monetary Policy Tightening To Avoid Asset Price Shock

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Former Reserve Bank of India Governor and economist Raghuram Rajan is batting for a steady rollback of the accommodative monetary policy by global central banks amid robust economic growth.

“The best that can be done at this point is a steady removal of monetary accommodation as economies look strong,” Rajan told Bloomberg in an interview. He cautioned against “pushing it to the last limit” as it could “affect prices considerably if it comes as a shock”.

Rajan, who had famously predicted the 2008 financial crisis, said unlike in the previous decade, there is some support for the asset price inflation seen right now.

Growth is strong for the first time across the world...With all the engines firing on the real side, there is some optimism.
Raghuram Rajan, Former RBI Governor

According to him, the concerns are now centered around two factors. Even with strong growth and relatively lower unemployment, wage inflation is not really visible. The second factor is the debt levels that have "built up in these go-go years", he said.

Here are edited excerpts from the interview.

You were famous in 2005 for warning policy makers on the dangers of rising asset prices, are you concerned again now about asset price inflation?

Whenever there is asset price inflation you have to ask yourself, why is it there? And clearly there are some supports for it. Growth is strong for the first time across the world. You’re seeing Europe come back very strongly in the last few quarters and Japan is going the normal way it goes – a country with a labour force declining at one percent a year, for it to grow at one and a half percent every year is great. The U.S. is doing reasonably well. With all the engines firing, on the real side there is some optimism. The concerns have to do with two factors, one is the monetary side and second is the financial side. On the monetary side, when do we see inflation? If in fact you have strong growth, you have economies at levels of unemployment which have not been seen for a long time, when do we see more wage inflation, when do we see that translate more into goods inflation, that’s the question on the monetary side. When that happens, you will find interest rates picking up more strongly and that will have an effect on asset prices. The other factor is the financial side. How much debt have we built up in these go-go years. On the retail side, the government side, the corporate side? Covenant-lite loans are at an all time high at this point of time. The question is at that point when interest rates start picking up, when liquidity seems a little less available than it is now, do we see a substantial reaction on the financial side?

When does this stop becoming just a talking point among academics on Twitter and become something that policy makers need to address?

The question is what do you do to address it and I think the best that can be done at this point is a steady removal of monetary accommodation as economies look strong, let us not try pushing it to the last limit. I think as you remove monetary accommodation, you signal also that the financial side needs to adapt and you give it time to adapt which is Important. So the build up of leverage that you see, both the Implicit leverage in positions as well as the explicit leverage in debt, I think that will start tapering off if in fact there is a signal that accommodation will be taken off.

You have to do it in a steady way because you could affect asset prices considerably if it comes as a shock.

You don’t think the argument that we can let rates stay where they are because we are not seeing any inflation is worthwhile?

Central banks obviously are forward looking. They have to ask ‘is this going to stay the way it has been going forward?’ And the one thing that has changing is, earlier you had slack somewhere in the world. Today with unemployment coming down across the world, the sense has to be that there is less slack. As a result, the competitive pressures across the world which kept wage growth down may not show up as much going forward. Wage growth will possibly pick up. You have already seen inflation in some countries like Canada is picking up more strongly. The second aspect of this is central banks are also at the back of their minds thinking about financial sector risks. That is not in the front of the mind, front of the mind is inflation but if financial sector risk is also building up, we should not surprise the world suddenly with an inflation report that shows we are way behind the curve. That would suggest, so long as this uncertainty stays, steady slow removal of accommodation makes sense.

A lot of people talk about emerging markets and say are we looking at a 97’ kind of crisis?

They are in a much better position than they were even 4-5 years ago. They have reformed, some of them have focused on inflation targeting. Some of them have got it down. To that extent, they are in a better position but that doesn’t mean they are immune. There is a huge amount of capital that has flown towards emerging markets. I’ve seen some studies which suggest a substantial portion of it is as a result of easy monetary policy in the advanced countries which pushes capital that side. As policy reverses, there could be some reversal. The hope is both with stronger growth there as well as better policies, they are in a better position to withstand the reversal. So I think, Tequila crisis, etc., are situations where governments were relatively unprepared. I think they are in the better position, not immune.

Do we need debt-fuelled stimulus, as in the U.S. tax plan?

Some of the analyses of the U.S. tax plan suggest that we will get stronger growth next year. But you have to ask with the levels of unemployment where they are, what you really need is a redistribution of that growth towards the jobs that people need and aren’t able to fill right now because of the jobs that are available are not the jobs that suit their skills. There has to be a certain amount of redistribution, some of that happens naturally with stronger growth but the question you have to ask yourself is with this level of unemployment is there more space in the labor market as we get stronger growth? If we don’t what will happen is you will get stronger growth from the fiscal side but you get the fed having to move faster offsetting that from the monetary side. We have to wait and see what happens but clearly that is a danger looking forward.

Is the Fed the central banker to the world?

The Fed sets the tempo across the world. There is no market immune to the dollar. Dollar has an enormous effect and the Fed of courses influences the dollar. Many graduate students in our conference are suggesting that dependent countries are on the exchange rate vis-à-vis the dollar which is of course determined by Fed action to some extent. We are in a very integrated world. I think the Fed has been measured as it exists, but very clear about where it is goings.

Do you think people are getting tougher on banks?

We needed to get tougher during the financial crisis and after that. But I do think regulation tends to follow a cycle. In bad times it gets excessively tough and in good times it gets excessively weak. We’ve put a lot of regulations on banks. It is about time we look at them and decide is it enough? Is it spread well enough across the system. There are specifics which result from banking theory which I want to talk about today but broadly the question is how much is enough, I would prefer a level playing field across the financial sector. Don’t overregulate one side relatively unregulated because the risks then transfer over to the underregulated side. We may be in some danger of doing that.

Any advise for J Powell?

I can’t advise him, he has tremendous amount of experience. I’m sure the central bank will continue its sound activity.

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