Thursday, May 19, 2011

Slamming the accelerator while hitting the brakes

The #1 problem of Indian macroeconomic policy is the inflation crisis. From February 2006 onwards, in every single month, inflation has exceeded the target zone of four to five per cent. I'm measuring inflation as the year-on-year change of the CPI-IW. The latter is the best measure of the overall price level in India today.

This macroeconomic instability is damaging the ability of economic agents to plan and invest for the future, because it's hard to envision interest rates and prices when faced with such high uncertainty. High inflation thus damages growth.

Many people in India like to make excuses about inflation. One day, inflation is about the price of onions. Another day, inflation is about a global commodity shock. Many people like to open up the sub-components of WPI and explain away inflation by saying "but it's only concentrated in a few things which make up x% of the overall basket". And so on. While each of these idiosyncratic factors can generate relative price changes, they cannot explain sustained price rise of the overall household consumption basket.

Sustained and persistent inflation is not an act of god. It is made by mistakes in macroeconomic policy. It can and should be contained by solving these problems of macroeconomic policy.

On May 3, Dr. Subbarao announced a fairly good policy statement. It continued to talk about WPI while the best inflation measure is the CPI. But for the rest, it was the first time that RBI was starting to take the inflation crisis seriously. And that was good. Also see an Indian Express column by Ila Patnaik on May 6.

Sadly, RBI's commitment to the problem of inflation lasted for six days. On 9 May, Dr. Subbarao did a speech in Switzerland which essentially robbed RBI's stance of credibility. Ila Patnaik has a column in the Indian Express about the damage that this speech has caused. You might like to also see this old column of mine on the problems of RBI.

Consider the date on which the rate hikes began. Compare two alternative worlds:
  • In one world, RBI says: "We care about inflation, we will do what it takes to get y-o-y changes of the CPI-IW back to the target zone of four to five per cent". And the rate is hiked by 25 bps. And this is repeated a short while thereafter. And so on. In this world, the expectations of economic agents get modified alongside the rate hikes.
  • In another world, every time RBI raises rates, RBI says "actually we are not so serious about inflation". In this world, the expectations of economic agents do not get modified alongside the rate hikes.
Monetary policy works by directly crimping aggregate demand (e.g. driving up the EMIs that people pay, or the cost paid by firms for working capital) and by reshaping expectations and thus the decisions about wage / price hikes. By damaging the latter, RBI has imposed more of the heavy lifting upon the former.

What does it take for RBI to persuade us that they are serious about inflation? Commitment to the floating exchange rate (thus removing this conflict of interest that can damage monetary policy), movement on the DMO (thus removing another conflict of interest that can damage monetary policy), and sound monetary economics going into speechwriting (and future monetary policy formulation). By failing on all three scores, RBI is generating a situation where there is no commitment that in the future, RBI will fight inflation.

Whether RBI wants it or not, India will fight this inflation crisis, which is the #1 cloud on the horizon of India's macroeconomic policy. The politicians require CPI-IW inflation to be back to the four-to-five per cent zone by late 2013, well in time for the elections in 2014. The pressure is simply going to ratchet up. The only question is about how monetary policy will fight inflation. If the instrument of monetary policy is refashioned to fight inflation, then the amount of pain that has to be inflicted through rate hikes, that is required to get the job done, will be lower. If the instrument of monetary policy is mis-managed, then a bigger set of rate hikes are required to get the same thing done.

In the medium term, RBI needs to build a team of top quality economists, who gain street cred by exuding knowledge of monetary economics. In the short term, the least that is required to be done is to stop the flow of low quality speeches.


  1. The RBI cannot fight inflation. I understand the concept of aggregate demand, but do understand the failure of transmission mechanisms and the failure of adequate supply. It can at best control credit growth, which its you see the credit stats? its decelerating. increased provisiong? lowering credit supply. in an economy where 50% of the people dont have bank accounts and a similar number of people/corporates under the influence of the shadow banking system, putting the burden on rbi to reduce aggregate demand is no less than foolishness. In an index that is littered with production goods, rather than final goods, wpi and cpi-iw, remain inefficient indicators. The problem is not rbi, its fiscal policy that has been too loose...thats where the noose needs to be tightened. There is rampant goonda raj and vote bank politics being played in the name of social equity. otherwise we would seerural cpi lower than urban, whereas for better part of the period you mention, it has been higher.

  2. Growth vs inflation. Right from the government to the CII and FICCI, it was harped that RBI should not harm growth while tightening policy. Hence when inflation went on sustained uptrend, every economist worth his/her salt including the chief economic advisor gave excuses and urged RBI to take it easy.

    Now that inflation is seen as a real threat the same persons are urging RBI to fight it.

    Policy cannot really fight inflation. It can only highlight the risks. If inflation is a real threat why is the Rupee doing reasonably well? Money should have gone out of the country in droves, but it is coming in.

    It is good that inflation is now being recognized as a real threat. Tight monetary and fiscal policy strengthens the system, corporates are forced to work hard to innovate and keep margins stable, and consumers are forced to cut down on non essentials leading to better allocation of resources.

    Hopefully, past mistakes will not be repeated and that growth mantra goes out of the vocabulary.

  3. I find it weird that "authorities" whether that be the finance ministry or the RBI should care about growth and even more stupidly project target rates of growth. Growth should be organic and the growth rate should be a statistic (that is not set out as a target to be met). It can't be the goal that is to be met come what may. Fix the policies and let the economy grow at whatever level it can. With bad policies, 9% growth has no meaning.


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