Disapproval of Raghuram Rajan’s policies as Reserve Bank of India Governor may not be the most politically correct thing to do today. The person who can be singularly credited with stabilising the rupee during September 2013 — when a fragile Indian economy witnessed speculative capital outflows that brought back memories of 1991 — certainly requires no certificates of nationalism from anybody.
But that should still not stop one from taking issue with RBI policies framed during Rajan’s eventful tenure. That includes the monetary policy framework focused on inflation targeting, which was formalised under his guidance through an agreement signed between the RBI and the Finance Ministry.
The new framework did not merely fix goals for inflation during any financial year and pin responsibility on the RBI for achieving the same. These explicit targets were set in terms of the consumer price index (CPI), as opposed to the wholesale price index (WPI).
The implications of it were not small. In the existing WPI (base year 2004-05), food items have a total weight of 24.31 per cent, while being as high as 45.86 per cent in the case of the 2012-base combined (rural + urban) CPI.
Now, we know that raising interest rates can do very little to bring down prices of onions, potatoes or pulses. Monetary policy tools are effective in controlling inflation that is mainly demand-led. For example, making home loans expensive can help cool overheated property markets. But food inflation has more to do with supply-side pressures. In this case, it is rising prices — not higher interest rates — that actually help reestablish equilibrium between demand and supply, by suppressing the former and stimulating the latter.
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While CPI inflation in India traditionally always ruled higher than WPI inflation, the differences weren’t significant enough to impact conduct of monetary policy. The RBI’s key short-term lending or repo rate of 8 per cent in May 2014 — when the current government came to power — was higher than the WPI inflation of 6.2 per cent and a tad below CPI inflation of 8.3 per cent. With the base rate charged by banks at 10-10.25 per cent, producer-borrowers effectively paid 4 per cent interest in real terms. The repo rate, then, ranged roughly between WPI inflation and the minimum lending rate of banks.
But the divergence between CPI and WPI inflation started widening significantly from around August 2014, as the accompanying chart (left) shows. By November, WPI inflation had entered negative territory and remained there for the next sixteen months. The monetary policy framework agreement, which committed to meeting inflation targets anchored to the CPI, was entered into in February 2015. At that time, the gap between CPI inflation and WPI inflation had already crossed 7.5 percentage points, and widened further to 8.8-9 percentage points by August-September.
This led to an unprecedented situation. On the one hand, producers were experiencing deflation, with the prices of their products falling year on year. But on the other, since the repo rate was being set with reference to CPI inflation — the WPI had practically ceased to exist for the RBI — and this was being brought down only gradually, producers were effectively now borrowing at double digits in real terms.
In August-September 2015, State Bank of India’s base lending rate was 9.7 per cent. Taking the WPI inflation of minus 5 per cent, it translated into a real interest rate of almost 15 per cent! Primary producers not using imported inputs — whose costs may have fallen because of the global commodity collapse — would have suffered all the more as a result.
The above situation was brought about solely by the RBI’s adoption of the CPI as the “nominal anchor” for inflation-targeting. True, the CPI inflation was also falling, but only slowly thanks to sticky food prices — on which the RBI, ironically, had no control. In recent months, we have seen CPI inflation going up again — and as before, the villains are the same old tomatoes, potatoes and tur or urad dal.
Defenders of Rajan’s monetary policy suggest that too much is made of interest rates. Investment and demand for credit is hardly influenced by these, they say, while noting that banks in 2007-08 were lending at 12-13 per cent and the repo rate itself was 9 per cent (as against 7.5 per cent now).
Well, the argument misses a simple point: For borrowers, what matters is not nominal but real interest rates. Through 2007 and 2008, WPI inflation averaged around 6.5 per cent, which means they were paying an interest of 5.5-6.5 per cent in real terms. But today, if the prices of what they are producing are barely increasing and nominal interest rates are still above 10 per cent, it means double-digit real interest rates. That surely isn’t conducive for investment or credit offtake.
Critics of the RBI’s policy of targeting CPI inflation are not entirely wrong in claiming that it has inflicted collateral damage to the Indian economy, by keeping interest rates too high for too long. The very fact that the success in meeting CPI inflation targets is predicated on what happens to food prices also, in turn, creates an anti-farmer policy bias. It naturally predisposes policymakers towards freezing minimum support prices, imposing curbs on farm exports and stocking limits at the slightest indication of prices going up, and opening up to duty-free imports.
We have seen these in ample measure in the last two years.