In a column in The Indian Express—“At the rate of?” (June12)—the chief economic advisor (CEA), Dr Arvind Subramanian, resurrected the issue of different real (i.e., inflation-adjusted) interest rates in India, depending on the choice of the inflation yardstick. He makes the point that real interest rates based on CPI are too high for the corporate sector—which is already suffering from being highly indebted—and thus slow the healing process.
The distinguished Dr Subramanian shied away from commenting on whether the current monetary policy stance—which is based on CPI inflation—is appropriate. In an attempt to encourage discussion in these “unusual times”, he floated a trial balloon of a blended inflation metric, using CPI and WPI inflation rates. This will, of course, yield lower inflation than based on the CPI, thereby justifying more monetary easing.
I used the word “resurrected” because the debate over the real interest rates in India isn’t new. Until Governor Rajan showed up, the Reserve Bank of India (RBI) was relying on WPI inflation to set its interest rate policy. The approach appeared to work for a long time but the RBI was unique to be targeting input price inflation with a significant tradeables component over which it had no control while overlooking retail inflation. This was contrary to the standard central banking practice of targeting consumer price inflation, and gave rise to several different calculations of real interest rates.
The suggestion of a blended inflation rate was talked about by a handful of analysts, including this author, from a different perspective when WPI inflation—like it is now—was lower than CPI inflation. However, unlike the situation today, RBI then was relying on WPI inflation for calibrating monetary policy. The main basis for the suggestion was that households were getting a raw deal in terms of real returns, which in turn could hurt confidence and undermine deposit mobilisation. A blend of CPI and WPI inflation, while not as good as a sole focus on CPI inflation, could at least position policy to offer slightly better inflation-adjusted returns to households. We all know how the script played out.
Giving rise to this debate again is counter-productive for several reasons. First, following the new monetary framework agreed between the government and RBI, CPI inflation is the legally binding yardstick for inflation. This was signed just four months ago, so it isn’t clear why the government agreed to it if it was unsure or had doubts about its appropriateness.
Second, a monetary policy framework cannot be temperamental and change depending on what constitutes “unusual times” or which metric yields lower real rates. Tomorrow, if commodity prices surge and WPI inflation, which is more sensitive than CPI to these prices, jumps, will a focus on the latter become the mantra?
Third, devising creative ways to make a case for lower interest rates misses the very basic point about why there is a wide gap between both headline and core components of CPI and WPI inflation rates. The collapse in WPI inflation, driven by the plunge in tradables inflation and weak corporate pricing power hasn’t adequately transmitted to CPI inflation.
Is this lack of full pass-through just a matter of time? Or does the wide gap reflect chronic supply-demand imbalances across several sectors—not just food but also health, education, etc.—catering to households? Do these imbalances offset the pass-through of lower commodity and weak corporate pricing power? If this is the case, then the government has a gargantuan task of fixing the supply side.
Fourth, a blend of CPI and WPI inflation rates short-changes the households. What is essentially proposed is that households do national service by accepting a lower inflation-adjusted return in order to facilitate lower cost of borrowing for businesses. Frankly, given the already high incidence of financial repression in India, households don’t need to do more national service!
Finally, the key responsibility of monetary policy is to ensure that households/depositors don’t lose confidence in the purchasing power of the currency. This is why CPI inflation is crucial. Monetary policy doesn’t target the health of the corporate sector. Weak corporate pricing power and/or their indebtedness can offer scope for monetary easing only if the drag from these ensures easing which is consistent with the CPI inflation target. The moving up in headline and core CPI inflation even before a meaningful economic recovery takes hold indicates that isn’t the case in India.
Deleveraging is typically slow. India’s unique circumstances, including its still-high retail inflation relative to other EMs and relative to where RBI wants it, make the deleveraging process even slower.
More should be done to speed up the return to health of the corporate sector. And yes, lower real interest rates will be useful. But the decline has to come about via a significant and sustained fall in CPI inflation. It surely cannot come about by risking a trial balloon which could fuel unnecessary misunderstanding about the government undermining the RBI and the new monetary framework that the sovereign is party to.
A more encouraging and effective strategy will be to convince investors and economists about concrete actions being taken by the government to achieve the medium-term goal of CPI inflation of 4%. That target appears impressive on a blackboard. However, achieving it in the backdrop of growth acceleration in a supply-constrained economy will be significantly more challenging that is being appreciated.
The writer is senior economist at CLSA, Singapore. Views are personal
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