How Reserve Bank of India Gets Trumped By ‘Irrational’ Choices of Middle Class

If the COVID-19 pandemic had anything substantial to add to our understanding of financial markets, it is that economic markets are not as good at self-control as Mahatma Gandhi. This led to the Reserve Bank of India being caught between a rock and hard place. From a monetary policy perspective, it is unable to determine whether to tackle inflation or go for growth measures. If they treat the former, it will affect consumption and aggregate demand and if the latter prevails, a surge in prices will widen the inflationary gap and investor sentiment is bound to dwindle. When inflation peaked in September 20222 and spiralled out of the purview of the Reserve Bank of India, the monetary policy committee had to step in, which led to a hike of fifty basis points in the repo rate by the central bank. Economists view it as a domino effect of multiple equilibria stress on central banks around the world, which are under tremendous pressure to mitigate the marginal effects of transient shocks.India’s Inflation Target: Even As RBI Caves In, Monetary Policy Is in Govt HandsNeoclassical economics assumes that all choices made by economic agents are driven towards one logical objective: optimisation. With many agents engaging in the market, it would be stating the obvious that every agent would look towards minimising risk and maximising returns. To maintain economic equilibrium, if optimisation is the go-to model, what then explains the successive rising inflation, unhinged consumption patterns, and reduced government spending? Is this bimodality symptomatic of irrational economic agents? What rational behaviour can we contrast with it?One could allude to slow but gradual post-pandemic recovery as the main reason, but it still doesn’t explain the perennial questions raised above, which have resulted in long-term structural problems. “The pleasure which we are to enjoy ten years hence interests us so little in comparison with that which we may enjoy today”, argues Adam Smith. Is it, then, the case of pain being a more pungent sensation than the corresponding pleasure, which Smith argues? That despite India being a mixed economy which was 'barely impacted by global financial crises', we are frequently changing our high-frequency economic indicators to determine our growth trajectory?RBI Monetary Policy: Necessary for Appearance but Unlikely To Make DifferenceFrom manufacturing slowdown—which is now beginning to improve—and exchange rate disparity to an imperfect-rational middle class, there are many issues that ail the Reserve Bank of India’s monetary policy framework but for the paucity of space, let us analyse one: The middle class.The liberalisation-privatisation-globalisation-LPG policy in the 1990s led to the creation of an entirely new economic middle class which was believed to be a logical outcome. But, with the benefit of hindsight, what went unnoticed and still continues, was the behaviour of this class on the consumption-production spectrum and its impact on maintaining market equilibrium. And somehow our policy remains bereft of any learnings in this regard. In India, out of every three persons, one belongs to the middle class. By 2047, according to research by PRICE, it will make up more than sixty per cent of the total population. There has been a more than twenty per cent rise in the disposable income of the middle class, which means increased savings. In the last year alone, the annual household income of the middle class increased by a staggering thirty-one per cent. Fifty six per cent of annual income goes into savings.This has two impacts: firstly, given this succinct rise, our monetary policy should have been expansionary, but it’s been, for the most part, contractionary. Second, the purchasing power parity -PPP- has remained concentrated in this class alone, which means a deflationary gap for successive periods. According to Pew Research, during the Covid lockdown, poverty in India rose exponentially, beating china, which means facing the ghosts of credit risk and unemployment. RBI Rate Hike: Inflation-Hit India Needs Sound Policy, Not Hawkish MeasuresThe Reserve Bank of India’s significant policy efforts to keep inflation under control bear the imprints of how policymakers have understudied or undermined—wittingly or unwittingly—these market participants. Ipso facto, globalisation has made this problem universal. The misbehaving of economic agents, as economics professor Richard Thaler calls it, is fundamental to policy making, simply for the reason that policies and regulations are made for them in the first place. But policies are not made on an everyday basis. And anomalies like self-control, loss aversion and overconfidence displayed by economic agents are commonplace. The reason these anomalies continue to have a recurring effect on markets is that our central banking regulations are riddled with stress on data-driven models instead of psychology, which takes human nature as a vantage point.If economic policies have to have a performative effect in the market, the Indian central bank needs to concentrate most of its efforts on understanding the economic behaviour of the middle class, whose patterns are not in sync with the policies. The withholding of a huge quantum of income in the form of savings and irregular consumption will continue to create barriers in monetary policy and also bump all inflationary measures.If economic agents were entirely rational, they would consistently make the same decision given identical options, but often times people's preferences are dependent upon how the options are presented, which in economics is called the framing effect. It is an essential ingredient of Scandinavian states' economic policies. Central regulating institutions tend to pre-determine important growth indicators for any economy like production demand, investment level, labour output and consumption patterns. But, the markets have time and again revealed lacunae in this pre-commitment modelling and the central reason being undermining the psychological side of economic agents. Much like supply and demand, the rational and irrational spectrum significantly informs economic equilibrium as well as subsequent error correction models. If our economic regulator wants policies to have a performative effect, the latter spectrum merits serious consideration for what Thomas Kuhn calls a paradigm shift.(Dr Shahid Mohammad is a Developmental Economist. He is currently working as an Assistant Professor of Financial Economics at Dr Vishwanath Karad MIT World Peace University.This is an opinion piece and the views expressed above are the author’s own.The Quint neither endorses nor is responsible for the same.)

BECOME A MEMBER

How Reserve Bank of India Gets Trumped By ‘Irrational’ Choices of Middle Class

RBI must understand the economic behaviour of the middle class, whose patterns are not in sync with the policies.

Read Latest News and Breaking News at The Quint, browse for more from opinion

Topics: Reserve Bank of India Monetary Policy Monetary Policy Committee