The debate on whether or not Reserve Bank of India (RBI) should be pursuing an inflation-target exclusively was raked up again by the former RBI Governor and former chairman of the Economic Advisory Council to the PM, Dr C Rangarajan, writing in The Hindu a few days back. We know that Rangarajan was an inflation hawk throughout his tenure at RBI and in the government. In his column, he advises the present RBI Governor to follow in his footsteps. The Urjit Patel committee also in effect recommends that RBI pursue inflation-targeting. This will, however, be a mistake.
In our country, inflation is a result of demand expanding at a higher rate than supply. In a poor and growing economy, where the policy objective is to raise the consumption levels of the majority, it cannot be anyone’s case that curbing private demand could be the measure to correct the ensuing demand-supply mismatch. That just hurts those who are already poor, as it effectively implies slowing down the economic growth rate, reducing employment generation, and increasing distress. The objective should, therefore, always be to rapidly expand supply capacities and often create capacities in anticipation of demand. That was, in a nutshell, the Chinese way for sustaining 10%-plus growth rate for three decades with only two major inflationary episodes.
We, on the other hand, keep yo-yo-ing around a growth trend, which, thankfully, has been rising but certainly not sustained. The supply response gets grounded because successive governments have not bothered to implement the necessary structural reforms to release investment impulses and encourage investors to expand capacities. As a result, inflationary pressures are built up in the system, forcing policy-induced contraction. The battle against inflation is led by RBI, which sees this as its main priority. Rangarajan is suggesting that fighting-inflation become RBI’s only priority and, if successfully executed, it will result in macroeconomic objectives being achieved. The critical question, however, is whether inflation-targeting will generate the much-needed employment without which our demographic dividend will turn into a demographic nightmare of horrific proportions.
There is clearly a trade-off between being an ‘inflation-targeter’, as Rangarajan would have RBI be, and promoting employment generation. An example here would suffice to demonstrate this. As an inflation-targeter, RBI would be biased in favour of an appreciated exchange rate for the rupee as all our imported intermediate inputs (energy and capital goods) and the final consumption products would become cheaper. This helps keep inflation down. But an appreciated rupee is poison for export earnings and attracting inbound tourists. Both exports and tourism are labour and employment-intensive sectors. Therefore, as an ‘inflation-targeter’, RBI will tend to sacrifice employment opportunities for price stability. Not so good.
In a similar manner, for curbing final consumption demand, RBI would prefer to use retail prices, both for its inflation-targeting and also for estimating the real rate of interest, which, according to the inflation-targeters’ gospel, should be positive to encourage savings and reduce consumption. However, for expanding employment, the investment cycle has to be ignited and the investor sentiment has to be improved.
Moreover, sectors such as real estate and automobiles, which have perhaps the largest linkages in the economy, are also sensitive to the real rate of interest. Therefore, the higher the real rate of interest, the lower will be the investment activity as well as demand for housing and automobiles. It is, therefore, critical that RBI correctly estimates this rate because if it waited for too long for the CPI-based real rate to become positive, it could well drive investment down and, with it, the much-needed employment generation.
An alternative method to estimate real rates of interest would be to use the prime lending rates of commercial banks and the WPI. If RBI would accept employment generation as one of its goals, it would take steps to ignite investment demand and raise the demand in the employment-intensive sectors like housing, automobiles and tourism. In this case, it would be advisable for RBI to use the difference between the prime lending rate of leading commercial banks (in place of the policy rate) and the WPI (in place of the CPI) to come up with its estimate of the real rate of interest. If this is substantially positive, it should signal to RBI that it is time for cutting the policy rate which will bring down the prime lending rate with it.
The accompanying charts present the real-rate of interest using the policy rate and CPI (as currently done by RBI) and by using the prime-lending rate and WPI. The difference is stark with the real rate of interest in the second case being well into the positive territory. This calls for a reduction in the policy rate which will signal to commercial banks the need for cutting their lending rates, thereby encouraging investment demand and demand for housing and automobiles. Moreover, this may well exert a downward pressure on the rupee which will surely have a positive impact on our exports. All this will help employment generation, which as we have argued must be the principal policy objective for the government, RBI and all policy-makers.
Moreover, investment activity is correlated (negatively) with the real rate of interest using the prime lending rate and the WPI. Therefore, the argument put forward by RBI and its supporters that there is complete lack of such correlation is refuted. Thus, by not reducing policy rates and, thereby, not inducing the banks to lower their own prime lending rates, RBI is, in effect, dampening investment and, consequently, employment-generating impulses in the economy. Not good.
There is another argument doing the rounds, that with the banking sector already weighed down by large volumes of stressed assets and non-performing loans, encouraging more credit off-take at this stage will only worsen the situation down the road. By cutting rates at this stage, economic growth may be pumped up but only for us to find ourselves in a much bigger mess later on. This argument is akin to leeching the patient of all bad blood before you give her any medicine to cure the infection. It will surely result in the untimely demise of the patient or will significantly debilitate her. Instead, by generating more investment-demand, encouraging the housing and automobiles sectors and attracting more tourists, the economy could be spurred and the companies with large debts may find it easier to service these once incomes are rising again. And more importantly, it will expand employment opportunities which, along with rising investment can start a virtuous cycle. One hopes that RBI will not only deny the temptation to be an inflation-targeter but also help us all by taking the steps to re-ignite the investment cycle, raise economic growth and, along with it, expand employment.
By Rajiv Kumar & Geetima Das Krishna
Kumar is senior fellow and Das Krishna is senior researcher at Centre for Policy Research, New Delhi