Urjit Patel Should Speak Up on Demonetisation or Lose Credibility

If the markets capitulate, we will need a central bank that communicates a plan of action, not one that stays silent

Central bankers are often called Masters of the Universe. No period in financial history has proven this more thoroughly than the aftermath of the global financial crisis (GFC). It was the central bankers’ unorthodox methods – especially those in Western, developed economies – that saved the financial system from falling off a cliff and in turn, saved the real economy from The Great Depression-like economic circumstances.

Within this economic landscape came more power. Central banks in advanced economies became more political and their supervisory and regulatory powers expanded greatly. Central bankers now routinely try to influence and shape economic policies well beyond their mandates and competence.

Many central banks have increased the scale and scope of their (quasi-) fiscal and redistributive operations including, in the case of the European Central Bank (ECB), redistribution between tax payers and beneficiaries of public spending of different nation states.

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Since the end of the GFC's acute phase, the conduct of monetary policy, whether conventional or unconventional, has been poor at best, and at times dismal.

Many central banks persist in the delusion that they can set both price and quantity in the financial markets they operate in. They have ignored the expectations hypothesis of the terms structure of interest rates. On many occasions, they have engaged in forward misguidance and communication.

They exhibit excessive and/or asymmetric responsiveness to high-frequency asset market movements and volatility. They overestimated their capacity to boost aggregate demand. They have failed to prepare for the next cyclical downturn by not lowering (let alone eliminating) the effective lower bound on nominal interest rates.

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There has also been a complete breakdown of coordination between central banks in the developed and emerging economies. For instance, the US Fed, the provider of the only serious global reserve currency, failed to arrange swap lines with leading central banks in the emerging markets during the Taper Tantrum.

Ben Bernanke and Janet Yellen of the US Fed, Mario Draghi of the ECB, Haruhiko Kuroda of the Bank of Japan and a host of other central bankers have deployed communication as an effective policy tool.

While every analyst has a bleak forecast on how demonetisation will affect economic growth, inflation prospects, hit corporate earnings and consumer sentiment, the actual data may just be much worse than the median forecasts. If there is indeed capitulation in the markets, we must have a central bank that communicates its plan of action rather than one showcasing utter confusion by virtue of its silence.

In today's world, silence is the worst enemy of any central bank. The Reserve Bank of India and its Governor, Urjit Patel, must step up their game or they stand to lose whatever credibility there is left after the recent demonetisation saga.

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(Published in an arrangement with IANS.)