Calling RBI: We have a problem

Written by Surjit S Bhalla | Updated: Sep 20 2014, 09:44am hrs
In its presentation to the G20, 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 Governor Raghuram Rajan strongly hinted that it was too early to cut rates because of persistently high inflationand 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 my previous column (FE, Monetary policy irrelevant for inflation, MPII hereafter, goo.gl/jcA2l5), scant proof has been provided by RBI about the causes and/or the persistence of high inflation in India. Lot of talk, yes. Evidence and reasoned argument, no.

Click here for graph

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 rise, got to do with either increasing or declining inflation in India

In MPII, 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 2006-2012, MSP rose at an average rate of 12.1% for all food crops including rice and wheat. To put this into perspective, farm prices in 2012 were double their level in 2005. Average non-food CPI inflation during this time-period was a much lower 8% annual rate. Procurement prices act with a one-year lag and given that these prices have risen at an average of less-than-5 % over the last two years, it appears that this structural cause for persistent high inflation has a considerably diminished presence today.

What are the other causes of inflation that RBI/IMF might be thinking about (might is the operative word because try as I might, I havent found an explanation from them about either the cause of the high inflation, or the recent decline, especially in 2014)

For long, the 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, i.e., output-inflation tradeoffs. This thinking has the following history. Money-supply growth as a cause of either inflation or output was dispensed with circa 1980s in the US, and a decade or so later in Western 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 (MPII documented this ineffectiveness for India), then what are the gentlemen at RBI and IMF collectively smoking Their argument is that you need a tighter monetary policy to bring down inflationbut 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, i.e., 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 RBI and the 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 thatno 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 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 dowhether it be labour laws, ease of doing business, land acquisition concerns, or tax bottlenecks. This will help growthand inflation.

There is another explanation. Many analysts believe that inflation is cyclical, not structural, and this perhaps causes them (and RBI/IMF) to miss the macro forest for the myopic 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 accompanying table presents estimates for several indicators of inflation according to two different methodsyoy, preferred by RBI, and SAAR, preferred by most analysts and central bankers outside of India. It covers four sub-periods over the last fourteen years. No matter what the indicator, inflation is significantly down in 2014. RBI has a CPI target of 8% for December 2014; it is likely that that figure will be closer to 7%. Non-food CPI for the first eight months of 2014 is registering a 7.2 % inflation, down from an average 9.2% in 2009-13. Both WPI and core WPI (SAAR) are registering a low 4% rate.

RBI, like the US FED, 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 RBI, and for that matter, the 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 dont matter anywayand that just might help!

The author is chairman, Oxus Investments, an emerging market

advisory firm, and a senior advisor to Zyfin, a leading financial information company. Twitter: @surjitbhalla