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ExplainSpeaking: What are the pitfalls of RBI continuing to prioritise economic growth over inflation?

The easy money policy today could lead to high interest rates in the economy tomorrow

Written by Udit Misra , Edited by Explained Desk | New Delhi |
Updated: August 24, 2021 9:54:51 am
A pedestrian walks past the Reserve Bank of India (RBI) building in Mumbai

Dear Readers,

Last week, India’s central bank released several key documents that further shed light on the challenges faced by the Indian economy as well as the RBI (as the authority regulating the monetary policy of the country).

Many of you would recall, the key dilemma facing the RBI in the recent past has been the sharp trade-off between economic growth and inflation. That’s because, since November 2019, India’s inflation rate has been persistently high and economic growth rate persistently low. However, between supporting growth and containing inflation — the two require diametrically opposite policy responses — the RBI has repeatedly favoured the former. This is a choice that pre-dates the Covid-induced disruption. You can read this detailed explainer of why RBI has been doing so.

In this regard, of all the documents released last week, two stand out. One, the “minutes” of the Monetary Policy Committee, which announced, earlier in the month, the latest bi-monthly review of monetary policy. Two, the “state of the economy”, an assessment by the RBI, as part of its August Bulletin.

Between the two, they provide a comprehensive picture about three important issues:

  • The anatomy of India’s inflation: how much inflation is there, what is causing it, where does India stand in comparison to other countries etc?
  • Why does the RBI continue to look through the high inflation that every Indian is facing?
  • What are the pitfalls of this strategy?

What is the inflation rate?

Before one looks at the exact numbers, it would help to understand what inflation really is. Simply put, the inflation rate is the rate at which prices rise. One could calculate the inflation rate for a specific commodity, say, milk, or the general price level.

An inflation rate of 4% simply means that a commodity, which was priced at Rs 100 exactly a year ago, is now priced at Rs 104. If the inflation rate stays at 4% in the coming year then exactly a year from today that commodity would be priced at Rs 108.16 — an increment of Rs 4.16. If this rate of inflation stays the same, this commodity would be priced at Rs 121.66 at the end of five years.

The 4% mark is crucial for India because that is the level of inflation that RBI is legally required to target. In other words, that is what the RBI wants the inflation level to be in India. To be sure, RBI is not free to decide this level. It is decided by the Parliament, which has, by law, asked RBI to keep the retail inflation rate in the country at 4%. But the law allows the RBI some leeway; RBI can allow the inflation rate to fall up to 2% or rise to 6%.

It is also important to understand that these limits are for the “headline” inflation rate — that is, the overall retail inflation rate. As such, it is quite possible that while the headline inflation is 4%, the inflation in one specific commodity may be 10%, and in another, it may be 1%.

A certain degree of inflation in prices is considered necessary for economic growth to occur. But bigger problems arise when either the rate of inflation is quite high or when it keeps increasing. For instance, if the inflation rate is 6%, instead of 4%, then the commodity in question would be priced at Rs 134 at the end of five years. An example of increasing inflation would be prices rising at a faster rate each passing year — 4% in the first year, 6% in the next, 8% in the third, 10% in the fourth and 12% in the fifth. In such a scenario, the commodity would be priced at Rs 147 at the end of five years.

In evaluating the inflation rate, one should always consider what one gets in return on one’s savings or investments. The difference between these two numbers will determine whether one is better off or worse.

American humorist Late George Gobel put it quite evocatively when he said: “If inflation continues to soar, you’re going to have to work like a dog just to live like one.”

One should also think in terms of the impact of inflation on the poor — and there is no dearth of poverty in India — because they have very little money and most of it is spent (on meeting essential consumption needs) and there is very little left to save and invest. The poor are the worst affected by high inflation because it robs them of their (already meagre) purchasing power.

Anatomy of inflation in India

The following charts from RBI’s August Bulletin provide a good picture of how inflation has been persistently high in India in the recent past.

In the first set of charts, look at how the headline inflation line (dotted black in the left panel and just black in the right panel) has largely stayed close to, or above the 6% mark.

The charts on CPI inflation

But these charts also provide an idea about what has spiked the overall inflation rate.

Look at, for example, the green line (on the left panel) and the green bars (on the right panel); they show the retail inflation in food and beverages and how heavily it contributed towards keeping the overall price levels persistently high.

It is important to note that while the inflation rate in food may have decelerated in the recent months, the current prices are already quite high because of sharp (double-digit) inflation rates in the past.

Similarly, the second set of charts look at the prices of essential commodities such as pulses, vegetables and edible oils. As can be seen from the charts, barring cereals, most others have either seen a steady price rise (edible oils) or sharp season spikes (vegetables).

The charts look at the prices of essential commodities such as pulses, vegetables and edible oils.

Fuel prices have been the other big factor spiking the inflation rate. The table below highlights how sharp the increase has been across the board in just the past year.

Fuel prices have been the other big factor spiking the inflation rate.

The third set of charts show how right through 2020, India was one of those countries that stood out among comparable economies for suffering from high inflation.

Right through 2020, India was one of those countries that stood out among comparable economies for suffering from high inflation.

The table below, sourced from the RBI’s Monetary Policy Report released in April, shows how India struggled more than most others; Turkey is the only notable companion here.

India struggled more than most others

So why did RBI continue to look through persistently high inflation?

In the “state of the economy” document, the RBI states “the MPC voted to give growth a chance to claw its way back into the sunlight. After all, growth had fallen in 2019-20 to its lowest rate in the 2011-12…”

The RBI admitted that it had been “sacrificing” controlling the inflation rate in its bid to boost growth and that this was a subjective call.

“The MPC’s decision is backed with all available evidence — mobility-, activity- and survey-based. Yet it is, in the ultimate analysis, a judgment call because at the heart of the association between growth and inflation, a sacrifice is embedded. A reduction in the rate of inflation can only be achieved by a reduction in growth; an increase in growth is only possible by paying the price of an increase in inflation, always and everywhere. Called the sacrifice ratio in economics, the latest estimates for India suggest that for a one percentage point reduction in the rate of inflation, 1.5- 2 percentage points of GDP growth has to be foregone,” it states.

But what about inflation?

The RBI asks and answers this question: “But what if the MPC (Monetary Policy Committee) doggedly attacks the supply shock induced price pressures in spite of the current state of the pandemic-ravaged economy and as a consequence, economic activity wilts into depression? No amount of humility will wipe away the tears then.”

But shouldn’t controlling inflation be RBI’s top priority?

“Given the knife-edge trade-off imposed by the sacrifice ratio, the conduct of monetary policy has converged to a glidepath of graduated disinflation that spreads the inherent output losses over a period rather than a ‘cold turkey’ approach that applies the sledge hammer but causes large GDP losses which kill the nascent recovery and set back the Indian economy by several years due to precipitate policy action,” it states.

So clearly, notwithstanding the persistently high inflation, RBI is more worried about scuppering nascent GDP growth.

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Is the RBI justified in its actions?

RBI’s policy choice throws up clear winners and losers.

The poor, who have a higher “marginal propensity to consume”, will lose out due to high inflation. As would the savers in the economy. But the borrowers will benefit. A company (or the government itself) would be able to raise money at effectively negative real interest rates — because the inflation rate is more than the nominal interest rate — and use it to either pay off past debt or make fresh investments.

But, as the lack of unanimity in the Monetary Policy Committee, underscored earlier in the month, it is far from clear that the RBI’s choice is justified. In this regard, it is instructive to read what Prof. Jayanth R Varma, the dissenting member of the MPC, said during the policy review.

Verma was of the view that RBI should change its policy stance from “accommodative” (support growth) to “neutral”. His essential argument was three-fold.

Firstly, Verma questioned the suitability of monetary policy to deal with the impact of the Covid-19 pandemic given that the horizon is just getting extended.

“Covid-19 is beginning to look more and more like tuberculosis which kills a very large number of people every year without inflicting major damage to the economy; in other words, it is beginning to resemble a neutron bomb. The ability of monetary policy to mitigate a human tragedy of this nature is very limited as compared to its ability to contain an economic crisis,” he stated. Verma said “the possibility that Covid-19 will haunt us (though with lower mortality) for the next 3-5 years can no longer be ruled out”. And “keeping monetary policy highly accommodative for such a long horizon is very different from doing so for what was earlier expected to be a relatively short crisis”.

Secondly, Verma questioned the capability of monetary policy to address the adverse impacts of Covid-19.

“Monetary policy has very broad effects on the entire economy, and this was appropriate in the early phase of the pandemic which caused generalized economic distress. More recently, however, the ill effects of the pandemic have been concentrated in narrow pockets of the economy. At the industry level, contact intensive services have suffered heavily, while many other industries are now operating above pre-Covid levels. At the firm level, MSMEs have suffered severely, while large businesses have prospered. At the household level, the pandemic has been devastating for weaker sections of society, while the affluent have weathered it reasonably well. Geographically also, the pandemic has done its worst damage in around 100-200 districts spread across a relatively small number of states,” he stated.

As such, he pointed out that, instead of monetary policy, what is needed is a fiscal policy response. In other words, the government needs to step up and provide “targeted relief to the worst affected segments of the economy”.

The third strand of Verma’s argument was to recognise the threat from persistently high inflation.

“There are indications that inflationary expectations may be becoming more widely entrenched…After averaging above 6% in 2020-21, inflation is forecast to be well above 5% in 2021-22, and is not expected to drop below 5% even in the first quarter of 2022-23 according to RBI projections,” he pointed out.

For Verma, the “most worrying” aspect of all was the rise of expected inflation.

What are the pitfalls of such a policy choice?

Verma explained that ignoring inflation has its pitfalls.

First of all, it is important to understand the sanctity of targeting 4%. Yes, it can be argued that given the pandemic, the RBI should not get stuck with the 4% inflation target and instead target, say, 5% inflation rate since that too lies within the RBI’s comfort zone.

Doing so is not without risks.

“While there is some comfort that inflation is forecast to be below the upper end of the tolerance band, it is important to emphasize that the inflation target for the MPC is 4% and not 6% or even 5%. The tolerance band is designed to allow for forecast errors, implementation shortfalls and measurement issues. Treating 5% as the target would significantly increase the risk of inflation targeting failures,” he stated.

But more broadly speaking, Verma pointed out that a low long term interest rate is more important for inducing an investment-led growth than a low short-term rate.

“By creating the erroneous perception that the MPC is no longer concerned about inflation and is focused exclusively on growth, the MPC may be inadvertently aggravating the risk that inflationary expectations will be disanchored. In that scenario, rising risk premia could cause long term rates to rise. Easy money today could lead to high interest rates tomorrow,” he stated.

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