The Rudderless Bank of India

Written by Vivek Moorthy | Updated: Mar 12 2012, 07:07am hrs
Indias economy is undergoing hard times. Growth has slowed and corporate profits have been falling. For the fiscal year ending this March, barring data quirks, real GDP growth is likely to end up below 7%. This is significantly below the forecasts made a year ago by senior policy officials in Delhi and Mumbai.

Simultaneously, inflation has been very high despite a bumper harvest that has lowered food inflation from December onwards. The sustained rise in prices over the last few years is clearly manifest in the new lightweight R5 and R10 coins and is evident to one and all. Although the rupee has a symbol now, it has lost much of its substance. Policymakers are in a bind. In response to the slowing economy, RBI cut the cash reserve ratio (CRR) to 5.5% at its last policy meeting. Further cuts in the CRR and maybe interest rates may be under way. The financial markets and industry lobbies are expecting and aggressively demanding such cuts. At this juncture, whether RBI should try to boost the flagging economythat could tank drastically if the eurozone crisis worsensor solely focus on bringing inflation under control, is a tough call.

The focus of this article is not on what RBI should do now, but on how Indias economy ended up this way. In my opinion, RBI has blundered for the last three years. Its viewpoint has been that the current inflation originated in supply shocks, and then got transmitted to the whole economy by getting embedded in inflation expectations. The media and most economists uncritically reiterate this view.

I will argue to the contrary. Supply shocks should not be blamed. Rather, demand stimulus pushed GDP growth above its potential, and thereby pushed up inflation. By continuing to keep policy rates below expected inflation, RBI greatly contributed to this situation. Despite umpteen hikes in the repo rate, from 4.75% in early 2010 to 8.5% in late 2011, monetary policy has not been adequately tight.

The view that supply shocks have been the source of Indias inflation has been repeatedly espoused by deputy governor Dr Subir Gokarn since an inaugural address The Price of Protein in late 2010. Various RBI publications have been publishing and examining the contributions of protein and sub-protein items (meat, fish, eggs, pulses and also milk) to inflation. The press also reports this data quite often.

According to Dr Gokarn, as real incomes have been growing rapidly, consumers are upscaling to protein items at the expense of cheaper carbohydratesmostly rice and wheat. In this process, foodgrains get diverted away from direct consumption to feeding livestock for meat. At the same time, overall agricultural production has not kept pace with the rest of the economy. For the five years ending 2010, agriculture grew by 3.1%, while the rest of the economy grew by 10.0%. The result of growing demand and slowing supply has been a double whammy for food prices, and indirectly protein prices. On top of that, the huge food for work programme (MGNREGA) has boosted demand for food and food prices.

Unlike a typical supply shock (such as bad weather for one season), that pushes up food prices for a few months, or at most one year, the imbalance between demand and supply growth for food products is a multi-year phenomenon. This structural supply shock in Dr Gokarns words, thus pushes up inflation year after year, whether harvests are good or bad. This protein-centric view of inflation has been reiterated by him in a memorial lecture Food Inflation: This time its Different (November 2011).

Before analysing this view, for brevity and convenience, I shall label it the CPT (carbohydrate to protein transition) hypothesis about Indias inflation. Undoubtedly, such a nutritional transition has been taking place, and may explain food and more so protein prices. However, the CPT view of inflation is clearly contradicted both by classical monetary theory, and by recent evidence from Asian countries.

From the classical perspective, supply shocks cannot cause inflation. If the price of an item that takes a large share of the budget (say, food) goes up, the consumer has less remaining to spend on other items. Thus, as expenditure on other items falls, their price should also fall. As the relative price of food goes up, and that of other items goes down, the overall or aggregate price level should stay the same. As a first approximation, a supply shock will affect relative prices, but not the aggregate price level. This classical view evolved during the gold standard era, during which relative prices varied enormously. However, it is worth noting that the price level in the UK was about the same in 1913 as in 1776.

To apply this argument to the present situation, we need to deal with a growing economy with continuing inflation, since paper money has replaced gold. Thus a structural supply shock leading to a slowdown in agricultural growth will push up the inflation rate (as distinct from the price level) for food items, but not the overall inflation rate. As long as overall spending or nominal GDP growth (broadly determined by central bank policies) is unchanged, the inflation rate for non-food items will fall. In short, the CPT phenomenon will push up inflation for food and protein, but not overall inflation.

Adherents to the supply shock and/or CPT view are likely to dismiss the above arguments as monetarist theology or textbook mantra. Far from it. The classical view is neither theology nor mantra, but is rooted in simple logic and supported by robust evidence. This can be seen by looking at trends in inflationboth overall and for foodin India and comparable Asian countries.

To capture recent multi-year trends, I have taken the latest five-year period from 2006 to 2011. Based on the change in the price level over five years, the inflation rate can be calculated. Thus, for Philippines, the first country in the sample, the price level of 126.8 in 2011 implies an inflation rate of 4.8% (compound annual growth rate) over five years, while the price level of 136.5 for food implies food inflation of 6.4%. Further, from data in 2011, the relative price of food to non-food can be calculated as 1.14 (last column), starting from a ratio of unity in the chosen base year 2006.

What does the data indicate First in all countries, the price of food has risen relative to non-food. Second, within the food category, meat prices have risen more than overall food prices for most countries, but not for all. For Philippines and South Korea, the inflation rate for meat is lower than for food.

From a macroeconomic viewpoint, the most striking fact is that Indias overall inflation (9.2%) is way above all the rest. However, Indias food prices are not high relative to non-food, but well in sync with the other countries. Indias ratio is 1.14, identical to Philippines and very close to that of S Korea. Thus, Indias double digit food inflation (10.7%) should be attributed to loose monetary policy, not to CPT.

The comparison with our neighbouring giant China is particularly useful in elucidating the distinction between absolute and relative prices (or inflation rates) that lies at the heart of classical monetary economics. According to monetary economics, relative prices are governed by the microeconomic factors of technology and tastes, while the overall price level is determined by macroeconomic factorsnow, mainly central bank policies.

Overall, Chinas inflation is much lower, reflecting better performance by its central bank. However, the relative price of food to non-food in China has shot up to 1.51, much more than in India and all others. This has resulted in inflation rates for food and meat close to India, despite much lower overall inflation.

Indeed, the high 1.51 ratio could be partly explained by the CPT phenomenon highlighted by Dr Gokarn. Upscaling to meat may be more pronounced in completely carnivorous China compared to relatively herbivorous India! Chinas manufacturing miracle that pushes down its manufacturing prices would also have pushed up this ratio. Whatever the influences upon the ratio, the CPT phenomenon can at best explain Chinas high relative price of food, but it cannot explain Chinas low overall inflation.

In short, RBI has been floundering. By failing to anchor its policies in the basic axiom of monetary economics that higher inflation for one item does not imply higher overall inflation, it has lost control of inflation. It will now take a prolonged period of sub-par growth to bring inflation down. One can only hopegoing by Governor Subbaraos realistic reappraisal about Indias potential in a recent interview with the Wall Street Journalthat the Reddy rupee will not be allowed to become a raddi rupee!

The author is a professor of economics at IIM, Bangalore