Monetary tightening will only hurt growth. There are fiscal, administrative fixes.
The decline in CPI inflation to under 10 per cent in January is a welcome development but has little to do with monetary policy. It comes on the back of lower demand, sharply reduced government expenditure and lower food inflation, and is largely unrelated to interest rates. It also shows that inflation can be brought down much faster than the Urjit Patel committee report suggests. In India today, any policy that targets inflation through higher interest rates is not very wise.
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The RBI is right to move towards using the CPI as the measure of inflation. The ambiguity in the RBI’s choice of index — the CPI or WPI — could be maintained as long as the two broadly moved in the same range, especially given the wide gulf in our understanding of the transmission of monetary policy. But once the two indexes started deviating from each other, which has been happening since 2009, this muddle could not be maintained.
CPI inflation remains high largely because of food inflation, which can be addressed through administrative action and supply-side solutions. Cereal inflation can be contained by releasing some grain stocks, which are well above the quantity we need to maintain as strategic reserves, into the open market and by changing the open-ended grain purchase policy with its rising minimum support prices to one of limited procurement to meet the needs of the PDS.
For other food items — vegetables, pulses, oilseeds etc — part of the solution lies in reducing marketing margins and handling wastage, in more nimble international trade and increasing supply. The funding needed for preparing land for cultivation is a major constraint in increasing supply. Most small farmers don’t have the financial capacity to make the shift, and so persist with grain production. This year, for the first time, small SC/ ST farmers have been allowed to use MGNREGA funds for one-time land development. Thanks to this, many small farmers will shift to more lucrative vegetable production, especially those who live near cities where they can market their produce more easily.
The other major reason for inflation is the level and composition of government expenditure — Central and state — which leads to high fiscal deficits. The Centre is trying very hard to contain its fiscal deficit. But even if it hits its target of 4.8 per cent of the GDP, the combined fiscal deficit of the Centre and states will still be over 7 per cent — among the highest in the world. The composition of government spending, from investment to consumption, has fuelled inflation as it has led to higher demand and rising wages. The recently proposed increase in dearness allowance (by another 10 per cent) will further stoke inflation by setting in motion a broader wage-price spiral.
Given this, it is hard to understand how the RBI will curb inflation through monetary policy when its main causes are supply- and fiscal policy-related. The RBI maintains that there is no growth versus inflation debate. But in fact, tighter monetary policy is likely to hurt growth further, and resurrect the debate. Some analysts have argued that India’s Phillips curve has shifted, that its growth potential is closer to 5 per cent, and any attempt to grow faster risks stoking inflation.
But if supply constraints are a result of poor administrative decisions and fiscal and regulatory policies that crowd out private investment, the argument that the long-term growth potential of the Indian economy has been reduced from its historic highs of 7-8 per cent cannot hold. The incoming government must raise India’s growth capacity above 8 per cent to ensure that enough new jobs can be created and the momentum on poverty alleviation maintained.
Contrary to the disinflation path envisaged by the Urjit Patel committee, if supply-side policies can kick in more strongly, we can achieve the target rate of inflation much sooner and interest rates can be reduced to help sustain faster growth. The RBI seems to have been constrained by its own instrumentalities.
Only a hung Parliament with a weak coalition government could lead to an outcome where fiscal management and restructuring becomes difficult. A weak coalition government could also make it difficult to rationalise food, fertiliser and other subsidies, which are fuelling inflation. The Urjit Patel committee report seems to presume such an outcome with its unambitious disinflation path. Underlying its targets is an assumption that the main burden of disinflation lies with monetary policy alone. But a stronger, stable government could and must achieve the objectives set out by the report much sooner — by coordinating fiscal and monetary policies, and through administrative action.
By relying so much on monetary policy and using it inconsistently, the RBI has resurrected the growth versus inflation debate.
The writer is director general, independent evaluation office, government of India.
Views are personal