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Thursday, July 29, 2021

RBI, we have a problem

If supply-side problems are the major ailment, why not cut rates — since monetary policy can affect output without affecting inflation

Written by Surjit S Bhalla |
Updated: September 20, 2014 12:56:22 am
RBI-L If monetary policy does not affect inflation and for structural reasons inflation has declined, then a tightening will yield as much inflation reduction as loosening would increase it — zilch.

In its presentation to the G-20, the IMF boldly proclaims the following: “In India, more efforts are needed to continue reducing stubbornly high inflation and the large fiscal deficit… Sustainably lowering inflation will also require further increases in the policy rate.” And RBI Governor Raghuram Rajan strongly hinted that it was too early to cut rates because of “persistently” high inflation — and that he would not cut rates until the battle against inflation was “won”.

As is perhaps customary for the IMF, little evidence is provided for their extravagant conclusions; and as alluded to in the earlier article (‘Where monetary policy is irrelevant’, IE, September 13), scant proof  has been provided by the RBI about the causes and/ or the persistence of high inflation in India. Lot of talk, yes. Evidence and reasoned argument, no.

There is little doubt that inflation in India has been high and equally little doubt that inflation is now in a steady decline. The question remains: what has monetary policy, specifically in the form of a repo rate cut or raise, got to do with either increasing or declining inflation in India?

In the September 13 article, I had pointed to a structural cause for persistently high inflation in India over the last eight years or so — high procurement prices (or minimum support prices, MSP) for foodgrains. Between 2006-12, the MSP rose at an average of 12.1 per cent for all food crops, including rice and wheat. To put this in perspective, farm prices in 2012 were double their level in 2005. Average non-food CPI inflation during this time period was at a  much-lower annual rate of 8 per cent. Procurement prices act with a one-year lag and, given that these prices have risen at an average of less than 5 per cent over the last two years, it appears that this structural cause for persistently high inflation  has a considerably diminished presence today.

What are the other causes of inflation that the RBI/ IMF might be thinking about (“might” is the operative word because, try as I might, I haven’t found an explanation from them about either the cause of the high inflation or the recent decline, especially in 2014)?

For long, central bankers had us believe that monetary policy (either money supply growth or short-term repo rates) could affect both growth and inflation, as evidenced by the discussion of the Phillips curve, that is, output-inflation trade-offs. This thinking has the following history. Money supply growth as a cause of either inflation or output was dispensed with in the 1980s in the US, and a decade or so later in West Europe and Japan. The Phillips curve stopped being “operational” in the 1980s. Regarding interest rate policy, the evidence seems to be that it matters somewhat for output, but not at all for inflation. How else do you explain the desperation with which Western central bankers are trying to increase the stubbornly persistent low inflation rate in their economies?

If monetary policy is ineffective as a weapon against inflation in both developed and developing economies (the September 13 article documented this ineffectiveness for India), what are the gentlemen at the RBI and IMF collectively smoking? Their argument is that you need a tighter monetary policy to bring down inflation. But if (a) monetary policy does not affect inflation, and (b) for structural reasons (read MSP), inflation has declined, then a tightening will yield as much inflation reduction as loosening would increase it, that is, zilch. On the other hand, monetary policy can and does affect output without affecting inflation. So why not cut rates?

One can only speculate on the reasons behind the traditional, outdated thinking at both the RBI and IMF. Perhaps, they fear a return of these outdated inflation drivers. Fiscal deficits are often thought to be a cause of high inflation, but precious little evidence exists (scratch that, no empirical evidence exists) that explains any of the twists, or turns, of inflation in India. In any case, fiscal deficits are trending down. We could talk oil prices, but they are down significantly this year. Of course, such prices could go up again, but given a slowing world economy and with the US today as the largest oil producer, the oil inflation forecast is as likely to go awry as the prediction that Scotland would secede from Great Britain.

No matter where one turns, including both the RBI and the IMF, the recommendation for a more stable economy (higher growth and lower inflation) is that India must address supply-side bottlenecks in infrastructure. As India has begun to do — whether it be labour laws, ease of doing business, land acquisition concerns, or tax bottlenecks. This will help growth — and inflation.

There is another explanation. Many analysts believe that inflation is cyclical, not structural, and this perhaps causes them (and the RBI/ IMF?) to miss the macro forest for the micro trees. As inflation has steadily declined in India, the experts have revised their forecasts down, but say it is only a matter of time before cyclical factors kick in to generate higher inflation. But wait a minute: India had the highest inflation in the last six years, and yet had the lowest GDP growth rate. So, why should an improvement in real activity generate inflation?

Let us look at all the accumulated evidence on the trend of inflation in India since 2000. You judge for yourself whether inflation is a big threat to India today, as opposed to a year ago. The table presents estimates for several indicators of inflation according to two different methods — year-on-year preferred by the RBI, and SAAR, preferred by most analysts and central bankers outside of India. It covers four sub-periods over the last 14 years.

No matter what the indicator, inflation is significantly down in 2014. The RBI has a CPI target of 8 per cent for December 2014; it is likely that that figure will be closer to 7 per cent. Non-food CPI for the first eight months of 2014 is registering 7.2 per cent inflation, down from an average 9.2 per cent in 2009-13. Both WPI and core WPI (SAAR) are registering a low 4 per cent rate.

The RBI, like the US Federal Reserve, has a mandate for both growth and price stability. To be sure, it makes sense that policy change only occur once one is “sure” that inflation is under control. But how does one know when the eureka moment is? As a central banker, one needs to be cautious. However, does the RBI, and for that matter IMF bureaucrats, realise that there is a cost to the economy of delaying a rate cut and hence holding back growth? Possibly a large cost, since the economy in question has been operating considerably below par for the last three years. Maybe, as some argue, a rate cut is not really that important because supply-side problems are the major ailment of the Indian economy. If true, then why not cut rates, since rates don’t matter anyway — and they might just help!

The writer is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company

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