Raghuram Rajan, governor of the Reserve Bank of India, has been leery of the unconventional monetary policy tools used by central banks since the financial crisis. At some point, he said, pushing interest rates low seems to have the perverse effect of making people save rather than spend.
Perhaps the most cogent critic of Fed quantitative easing policy, Rajan says the asset-price boost that comes with it may disappear if these assets can’t grow into their valuation. That risks still haunts the U.S. economy, he said.
In an interview with MarketWatch on the sidelines of the International Monetary Fund’s spring meeting in Washington, he said he wants the Federal Reserve to raise rates at a measured pace. Doing so would give other leading central banks room to move away from unconventional policies as soon as there are signs of a recovery, Rajan said.
Rajan, 53, is on leave from his teaching post at the University of Chicago. He served as the International Monetary Fund’s chief economist and rose to prominence for raising prescient concerns about the serious risks facing the financial system well before the financial crisis.
The following is a transcript of an interview with Rajan, edited lightly for clarity.
MarketWatch: The latest International Monetary Fund report on the global economic outlook makes for dismal reading — why shouldn’t the Federal Reserve pause and wait until global conditions improve?
Rajan: If you read the writings of economists, it is not clear what’s keeping us still so slow, seven or eight years after the crisis. Ken Rogoff would say it is still the debt overhang and the deleveraging. [Robert] Gordon and others might say it is low productivity and still others may say it is the poorly understood consequences of population aging. But what do we do? And here I think there is more of a consensus that monetary policy pretty much has run its course. There are still guys who are looking for helicopter drops of money but I think that is a step sort of too far into the dark, where I am not sure there is a political consensus to do that in the major economies, if it comes to that.
And I am not sure we fully understand what will happen with that. You already see we don’t fully understand the consequences of negative interest rates. So I would argue that, certainly, monetary policy is probably not the policy answer any more, of choice.
What does that leave? It leaves small-scale reforms that we know will have positive effects — larger-scale structural reforms that may have short-term negative effects, and in the longer run should be beneficial, and possibly fiscal policy in some countries, although it matters a lot what you spend on, given that there is a lot of anxiety about the future already. So I think, in the industrial world at least, it seems as if unless we have a brain wave and understand fully what is really going on, it is really muddling through, doing what we can — which then means we have to be a little more pragmatic about growth. If you look at the IMF forecast, they start the year thinking growth will be much stronger than before and end the year revising down, down, down, down. The IMF is not an exception here. Everyone is doing this, which suggests that everybody sort of somehow thinks we’re going to make up that missing growth somehow when in fact it may not be possible. So I am not giving you a great answer. It is an answer of satisficing, rather than one that says we absolutely know the answer, here it is, my favorite instrument and push as hard as you can on it.
MarketWatch: For the European Central Bank, the Bank of Japan and the Fed, the best thing for now would be to stop moving in the easing direction?
Rajan: My sense is industrial countries’ central banks should probably consider whether they are doing more harm than good by easing further. I don’t think the benefits beyond a certain point have been that clear, and certainly the costs of staying in this ultra-accommodative phase for much longer will build up – the known costs – and then there are less-known costs. How much are we, with these policies, preventing adjustments that should take place. I know this has got a bad name, it is the “liquidationist” or “Austrian” view, but it is a very real question of whether we’ve allowed the adjustments to take place enough or whether we’re keeping too many inefficient firms alive.
MarketWatch: You’ve said you’re concerned with the wealth effect of quantitiative easing – that asset prices have gone up and investors are worried they are going to come back to earth.
Rajan: This is the problem of the bridges. If you build a bridge it has to reach to the other side. So I think a bridge that relies on wealth effects, you better hope that you got enough growth to justify the asset price increase which created the wealth effect in the first place. So there is some sort of virtuous cycle that gets kicked off which becomes self-fulfilling over time. The alternative is you kick off the wealth effect now, but over time people realize the wealth ain’t coming and then you have an asset price adjustment. I think the jury is still out on which one we’re going to go through.
MarketWatch: A big worry in the U.S. is that we’ve got to do more or we’ll end up like Japan. I sense from reading your speeches that you think this worry may be misplaced.
Rajan: The same factors are there in the U.S. as they were in Japan. Japan was a bank-dominated economy which went through this phase where the banks really had big losses, spent a fair amount of time denying the need to clean up, and then cleaned up quite rapidly. But then the banks didn’t have much of a business model post that clean up, and they’ve been looking for it for some time. I think the central problem with Japan, aside from the recovery from the great financial crisis they had, was the aging of the population and it was unclear what forces that triggered and I think we don’t fully understand. I think in the U.S. you don’t have the population aging, you have a much younger population, still vibrant. The U.S. cleaned up much faster. So that the question that is still outstanding is why is the U.S. not growing faster, why is productivity growth so slow? And I don’t think we understand the answer to that.
MarketWatch: Does the argument about secular stagnation fill the bill?
Rajan: I view secular stagnation as an argument that basically things were in place even before the crisis. I’m fully on board on that argument. The question is what was it that made it? Is it the slow productivity growth? If so, what is the answer to that? Is it aging? What is the answer to that? Secular stagnation sort of describes a phenomenon of slow growth over a long period of time which we may have masked by the debt bubble for a little while. I think we’re agreed that may be what is going on. But what causes the secular stagnation to my mind is the clear question that we don’t have an answer to.
MarketWatch: And how to get out of it.
Rajan: And how to get out of it, absolutely.
MarketWatch: Fed Chairwoman Janet Yellen has taken to talk about the neutral interest rate, saying it is currently low by historical standards, and justifies an accommodative stance. What is your take on this?
Rajan: Take any model you want. If inflation is relatively low and investment is relatively low, my guess is you would come up with a very low neutral rate, because you want to pump up investment to get more aggregate demand and the low inflation suggests there is weak aggregate demand relative to supply. And I guess you also want to pump up consumption because investment alone won’t do it. You want to bring down savings and domestically you want to bring up investment to increase domestic demand and so consumption and investment work together. So in that kind of model, it seems as if the equilibrium interest rate is strongly negative. If you push it down low enough, things sort of iron out. But the question you have to ask yourself is — is it possible that consumption behaves perversely with respect to interest rates beyond a certain point?
This is the point that a number of people have been making, which is if I push interest rates below a certain point, the income effects start becoming greater than the substitution effects. The usual point is I push down interest rates – I say, “wow, it is better to consume now than to save,” and I consume. But what if I have an end-of-life goal in terms of savings and I push down interest rates really low and I say “wow, I really can’t meet my savings goal. I am going to be on the streets when I am old, so I better save some more.” That is the perverse effect of low interest rates.
You could get savings increase rather than decrease. And as far as investment goes, it is not clear to me that the key constraint on investment is interest rates. It may be aggregate demand. But if there is this perverse effect of interest rates on consumption than you are not helping aggregate demand, either. We don’t understand why, at such low interest rates, people aren’t investing, but they’re not. I think the constraints may be other than the cost of capital. So, in other words, I am saying you are pushing down interest rates but you are not having the effect you desire of increasing aggregate demand.
MarketWatch: So the Fed should continue to inch interest rates up?
Rajan: For sure, more moves in the direction of accommodation ought to be thought of very, very, carefully. Because we haven’t seen all the moves so far pay off. And at some point, like the generals in World War I, sending people over the trench and seeing them mowed down, you start asking whether this tactic actually works. And you can’t keep saying more, more, more, right? So I think we’re about at that place where we need to ask is more the answer? That doesn’t mean less is the immediate answer. The problem with monetary policy is that changes matter. From where you are, you change very abruptly, you cause a lot of disruption. You have to have a measured pace of change. But it is probably not towards more accommodation, in my view.
MarketWatch: I heard from criticism of you this week that you wanted the Fed to move cautiously and now you’re saying the Fed is not moving fast enough — and that you will never be satisfied.
Rajan: I am not saying the Fed is not moving fast enough. In fact, I think the Fed is weighing things reasonably. What I am saying is that it is probably about time that, as the economies strengthen, we get out of this period of exit. I mean I’ve always been saying the fundamental problem is this period of extended monetary policy accommodation. The various measures, one after the other. Once we are in the measure, I’ve also been quite consistent in saying, let’s be careful in what we do to take us out because you’ve stretched the system so much, that if you do it very abruptly, it breaks. That is still my view, that we should do it at a measured pace. But we should do it. I’m not saying we should stay in it for much longer because it is weakening the system.
MarketWatch: You are famous for your Jackson Hole paper warning about the risk to the global economy from the financial system. What do you see now, is the financial system still a risk?
Rajan: No, I am more worried about lending by the financial system. You know there are two worries about the financial system: one, have they retreated too much from market-making because of all the capital charges etc. or liquidity regulation. And if and when that abrupt change in asset prices comes, is there the capacity to prop up the markets amongst the people who can take the other side, or are they relatively thin.
The second one is, you hear across the globe, and I don’t know how to weigh this against the level of complaint, but it is true that small and medium enterprises are generally starved of credit. But have we increased the regulation on risky assets so much that they are even more starved? So one is small and medium-sized enterprises and the other is cross-border lending.
So again, I am being accused of two different views on cross-border lending. On the one hand, capital flows are dangerous. On the other hand, I am saying [there is] too little cross-border lending. I am actually saying cross-border lending and cross-border capital flows are good in a measured way, if they were steady, if they were reliable, if they financed risk, that would be good. Because there is a lot of knowledge that comes behind foreign capital in financing risk. The unthinking foreign capital which comes in because there is huge optimism over this country and as soon as that proves not-so-right leaves in a hurry, that causes a lot more volatility than countries can handle. And so that is what I think we have to be a little careful about — not get carried away with the capital coming in but instead trying to encourage the right kinds of capital to come in.
So I think there may be a missing segment of that capital now, the risk-bearing capital, perhaps, and this is something we need to understand better, because of all the regulations we’ve put on. Now, don’t get me wrong. We needed to re-regulate the banks. We had gone too far the other way. The question we have to ask now is have we regulated them properly or are there mismatches between what we desire of them and what we’ve done?
MarketWatch: The good kind of capital is absent?
Rajan: I think risk capital is probably at a premium in a number of emerging markets. And to the extent that risk capital is provided by external sources, it is worth looking at that.
MarketWatch: The Indian economy is the bright spot in the global economy. When other central bankers and finance ministers ask you for your secret sauce, what do you tell them?
Rajan: Well, I think we’ve still to get to a place where we feel satisfied. We have this saying, “in the land of the blind, the one-eyed man is king.” We’re a little bit that way. We feel things are turning to the point where we could achieve what we believe is our medium-run growth potential. Because things are falling into place. Investment is starting to pick up strongly. We have a fair degree of macro-stability. Of course, not immune to every shock, but immune to a fair number of shocks.
The current account deficit is around 1%. The fiscal deficit has come down and continues to come down and the government is firm on a consolidation path. Inflation has come down from 11% to less than 5% now. And interest rates therefore can also come down. We have an inflation-targeting framework in place. So a bunch of good things have happened.
There is still some things to do. Of course, structural reforms are ongoing. The government is engaged in bringing out a new bankruptcy code. There is goods and services tax on the anvil. But there is a lot of exciting stuff which is already happening. For example just last week, I was fortunate to inaugurate a platform which allows mobile-to-mobile transfers from any bank account to any other bank account in the country. It is a public platform, so anybody can participate. It is not owned by any one company unlike Apple Pay or Android Pay or whatever. I think it is the first of its kind. So technological developments are happening and making for a more, hopefully, reasonable life for a lot of people. Let’s see how it goes.
MarketWatch: How do you compare India and China? It is a natural question for Americans.
Rajan: I think, first, we’re about 10 years behind in the reform process of when we started and when they started and that reflects in the relative size of the economies — we’re about a quarter to a fifth their size. I think that we could catch up if we do the right things over a period of time. It is extraordinary what good policies they followed to get where they are, so we have to be very good at our policy making as well as our implementation. I think what people admire China for is how they have managed to get things done. Now we have some strengths of our own, and we should emphasize those — I think there is a significant amount of flair and creativity in the Indian economy and we have to try and capitalize on those as we are trying to grow. We shouldn’t follow the same path that others have followed. But that means working very hard and creating the appropriate infrastructure, creating the human capital that we need to succeed. Building up a good regulatory environment,light but effective, and, of course, building adequate access to finance.
MarketWatch: Your monetary policy seems like it could be described as opportunistic easing.
Rajan: I wouldn’t call it opportunistic easing. We’re still in an accommodative phase, which means as we see disinflation happen, we will find more room. Now, given all the pushes and pulls in the global economy, you can forecast but you’re not quite sure your forecast will come out. So, we’re sort of a little more data-driven than we would be in more normal times. As the data come in and we get more certainty about how things are playing out, we will act accordingly.
MarketWatch: When you say data, does that include the monsoon?
Rajan: The monsoon is very big in India for a couple of reasons. It does significantly influence sentiment in rural areas, rural demand. It certainly affects about 50% of our population which is tied in some way to agriculture. Only 15% of value-added is agriculture and that is still falling, but many people have rural links. So the monsoon does impact all that. It has a moderate impact on food prices because good food management can alleviate the effects of the monsoon but if we have a bountiful monsoon than we don’t need effective food management to get lower food prices. We’re all keeping our fingers crossed. The good news seems to be that the meteorological department is saying it is probably going to be a good monsoon.
MarketWatch: I see your term is up in September.
MarketWatch: Is it going to be extended?
Rajan: It is a question that has to be answered.