March 18, 2010 1:37:36 am
The sharp rise in inflation to 10 per cent is a cause for concern. Headline inflation will get worse for a few weeks and then it will decline. Policy-makers have to keep that in mind before raising interest rates. The RBIs policy mix is mostly on the right track.
Inflation remains a worry as the consumer price index (CPI) is continuing to rise. On a month-on-month,seasonally adjusted basis,the CPI for industrial workers rose at an annualised rate of 20 per cent in January. It suggests that when the year-on-year data comes out,which is what we usually look at in India,the numbers will be worse.
At the same time,the prognosis for inflation is largely positive.
After a sharp increase in food prices from June to December 2009,food inflation,measured on a month-on-month basis with seasonal adjustment,has dropped to nearly zero. When volatile fluctuations of food and fuel prices are removed from the reckoning,we are left with WPI manufacturing,which is hovering around 5 per cent.
Inflation watching in India is done largely using year-on-year inflation. This picks up current developments on inflation with a lag of roughly six months. Hence,even though the latest information (month-on-month,seasonally adjusted) is showing an improvement for the coming six months,the year-on-year information is going to show high inflation. This will put pressure on the RBI to raise interest rates.
The RBI is a highly non-transparent central bank. Its communication does not reveal the full picture,and considerable analysis is required to unearth what is going on. In recent months,the RBI has apparently done little (other than raising the cash reserve ratio in January). At the same time,a deeper analysis shows a significant monetary tightening that has been taking place without announcement.
Money supply growth is an important indicator of monetary conditions. This has come down from levels of more than 21 per cent in July 2009 to nearly 16 per cent in February 2010. Traditionally,reserve money grew because the RBI was focused on the exchange rate and was continually buying dollars. From March 26,2007 onwards,the RBIs behaviour on the currency market has shifted towards greater exchange rate flexibility. In the last year,the RBIs purchase of foreign exchange has dropped to near-zero levels. Under this flexible exchange rate regime,the rupee has appreciated from
Rs 50 to Rs 45.50. This shift in the RBIs behaviour has reduced the pace of injection of rupees into the economy. Another element of the story is low demand for credit,giving slow growth in non-food credit. Putting these elements together,money supply growth has slowed sharply over six months.
In addition to domestic monetary conditions,the major determinants of inflation in an open economy are exchange rates and world prices. With an improvement in the US economy,global prices are picking up. If the exchange rate remains broadly unchanged,the rise in world prices will be passed through to a rise in domestic prices in India. A rupee depreciation would have the same effect. The 5 per cent inflation rate in WPI manufacturing reflects this combination of world prices and exchange rate movements.Despite the deceleration in month-on-month inflation in the last two months,and the coming harvest which might lower food prices further,the RBI will need a sophisticated approach to inflation. It will primarily have to look at world prices and be concerned about potential rupee depreciation. When faced with inflationary pressure,policies which strengthen the rupee will help.
One channel for this is hiking interest rates. When the domestic interest rate is raised,more capital comes into the country,resulting in a rupee appreciation. The second option is to liberalise capital controls. Removing the barriers against foreign investment in the rupee denominated bond market would kill many birds with one stone: it would combat inflation,along with providing better financing for domestic industry and infrastructure projects.
In summary,there are two important mistakes in the Indian inflation discourse. The first is the use of year-on-year inflation measurement,which yields information about inflation pressures in the economy with a lag of roughly six months. The second is the notion that the RBI can influence inflation by raising rates. What mainstream central banks worldwide can do given a well-functioning bond market and banking system is not feasible for the RBI given the crippled bond market and banking system. Mechanically raising rates when inflation goes up is not particularly useful,given the malfunctioning monetary policy transmission.
A more nuanced approach,reflecting an empirical understanding of relationships visible in Indian data,is required. The RBIs communication on this subject needs to improve,combining a better analytical framework and an honest treatment of its trading activities on the currency market. Thus,for example,if the RBI chooses not to raise interest rates,as they are unlikely to have a direct impact on inflation,it should say so clearly,and explain why,describe how a quiet tightening has been taking place and what policy options are being chosen and why. Not doing so results,in general,in a situation like the present one where expectations of rate hikes build up,and the RBI comes under pressure from various quarters on its conduct of monetary policy.
Opposition parties have been raising a storm over inflation. The government and the RBI do not have adequate levers in their hands to control inflation. The most important instrument,the short-term interest rate that has worked in many other countries,does not work in India due to a lack of financial sector reforms. This inflation episode serves to highlight the problem caused by difficulties in the monetary policy transmission mechanism. The RBI and the government should actively focus on building financial markets and increasing financial inclusion that would make short-term interest rates an effective instrument of monetary policy.
The writer is a professor at the National Institute of Public
Finance and Policy,Delhi
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