On inflation, read the Bible

RBI’s economy review came a day before North Block’s. The latter at least says something

The Government of India, however, did not appear to have realised the gravity of the situation regarding inflation as vividly as the Board and took no action.” The Board is RBI Board and this quote is from a newspaper of March 23, 1948, reporting views of C.D. Deshmukh, then governor. RBI was set up in 1935, nine years after Royal Commission on Indian Currency and Finance (the Hilton Young Commission) recommended its establishment. In evidence before the Royal Commission, Dr Ambedkar said, “As regards the effects of a rising and falling rupee on trade and industry the point often sought to be made is that low exchange confers a bounty on trade and industry. But this is not the important point. The more important point is, supposing that there is a gain arising from low exchange, whence does this gain arise? It is held out by most businessmen that it is a gain to the export trade and so many people have blindly believed in it that it must be said to have become an article of faith common to all that a low exchange is a source of gain to the nation as a whole. Now if it is realised that low exchange means high internal prices, it will at once become clear that this gain is not a gain to the nation coming from outside, but is a gain from one class at the cost of another class in the country.” Inflation and exchange rates; a third quote, from the Bible now. “What has been will be again, what has been done will be done again; there is nothing new under the sun.”

On July 30, we had the first quarter (2007-08) review of macroeconomic and monetary developments (MMD). On July 31, we had the first quarter review of annual monetary policy (AMP). AMP has a sketch of the macro-economy, but it is more selective and less comprehensive than MMD. Now there are several private organisations that undertake such reviews. Therefore, for any government review from RBI or North Block to impart value addition, there must be analysis and policy prescriptions, not just description and data, also available from other sources. Government and quasi-government reports still don’t reflect this required transition. MMD has the following.

First, growth is robust, with real GDP growth of 9.4 per cent in 2006-07. Both industry (11.0 per cent growth) and services (11.0 per cent growth) did well, but agriculture registered 2.7 per cent.

Second, in 2007-08, RBI expects real GDP growth of 8.5 per cent and other external forecasts range between 7.6 per cent and 9 per cent.

Third, in 2007-08, Centre’s gross fiscal deficit/GDP ratio will be (budget estimates) 3.3 per cent. States will chip in with a deficit ratio of 2.1 per cent and will have (budget estimates) a revenue surplus in 2007-08.

Fourth, WPI-based inflation was 4.4 per cent on July 14, 2007. CPI-based inflation was higher (6.1 to 7.8 per cent in May/June, depending on which CPI), “mainly reflecting the impact of higher food prices. Pre-emptive monetary measures since mid-2004 accompanied by fiscal (duty reductions) and supply-side measures have helped in containing inflation.” The inflation target for 2007-08 is 5 per cent and going forward, 4.0 to 4.5 per cent. If analysis and policy prescriptions are the key, as they ought to be, this isn’t good enough. One would like to know if inflation moderation was caused by monetary policy, fiscal measures or supply-side changes. Since policy nuances are different, one can’t leave a disentangled sentence like that dangling. If CPI-based inflation was primarily caused by higher food prices, what does monetary policy have to do with that?

Fifth, “increase in asset prices has been significantly higher than that in inflation indicators based on wholesale and consumer price indices.” Wait a minute. RBI earlier pointed to increase in asset prices to argue there was general over-heating. RBI now admits the two are different.

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Sixth, merchandise export growth has slowed in 2006-07 and April-May 2007-08, especially due to gems and jewellery, textiles, chemicals and ores and minerals. A policy question remains unanswered again. How sensitive are Indian exports now to exchange rate appreciation? Is it the case that these sectors that slowed are more price sensitive?

Seventh, net capital inflows were $46.2 billion in 2006-07. FDI inflow was 19.5 billion, FDI outflow was 11.0 billion and ECBs (excluding short-term credit) brought in 16.1 billion. Foreign exchange reserves were 222.0 billion in July 2007. Rupee appreciation is inevitable and makes the Ambedkar quote relevant. How is it possible for an economy to do well without exchange rate appreciation? It seems to me MMD has said two different things. First, RBI doesn’t know what to do with capital inflows and rupee appreciation. With capital mobility, any attempt to control exchange rates (RBI intervenes in the forex market) has adverse consequences. Second, on the inflation spectre and interest rate hikes, RBI has almost said mea culpa, thus making the Deshmukh quote relevant. It is difficult for anyone to admit a mistake, least of all central banks. But if you read between the lines, that’s exactly what MMD has said.

Let’s move on to AMP, more linked to policy than MMD. “Going forward, monetary management would need to be watchful of movements in commodity prices, particularly oil prices, the elevated levels of asset prices and the re-emergence of pricing power among producers as potential threats to inflation expectations.” Howsoever much charitable you are towards RBI, you must admit this says nothing at all. Beyond withdrawing cap on daily reverse repos and hiking the cash reserve ratio to 7.0 per cent, both expected by the market, RBI had no changes to offer now. This brings one to a broader question.

Why are we fixated on this bi-annual monetary and credit policy ritual, with all its hype and media attention, a hangover of the control mindset era? No developed country has this. Changes by central banks have to be instantaneous and incremental, not at discrete points in time. The use of differential calculus brought in a marginal revolution in economics in the 19th century. Why do we still refuse to accept this? By the way, marginal analysis had no role to play in economic theory practised in former centrally planned economies. If capital mobility and exchange rate changes are instantaneous, why should monetary policy be different?

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The same Hilton Young was sent off to Africa as the head of another commission there. And in 1929, this Hilton Young Commission recommended closer integration between British East African and Central African colonies. There is probably a contrived parallel there. Globalisation doesn’t mean integration of tariffs, exchange rates and investment policy alone. It also requires integration of institutions and benchmarking to global norms. If policy reviews don’t tell us much, why have them?