Don't shoot the RBI Guv: Why a rate cut is more in Jaitley's hands than Rajan's

The government wants the Reserve Bank of India (RBI) to bring down interest rates now that inflation appears to be moderating. RBI Governor Raghuram Rajan is not convinced inflation is truly down and out, leading some economists to wonder why Rajan is so obsessed with this one economic number: the Consumer Price Index which stood at 7.8 percent in August 2014. Surjit Bhalla, writing in The Indian Express gives 10 reasons why inflation won’t raise its ugly head for a while.

However, Bhalla is dialling the wrong number. He should try calling Arun Jaitley once he is a bit better. At any point of time, fiscal policy is more critical to inflation than monetary policy for it has more options to deal with the problem. A finance minister can incentivise more production to address supply side issues, he can offer subsidies to dent retail prices, he can cut import duties to bring down prices in specific commodities, and he can influence both demand and supply through tax policies as long as he stays within prudent fiscal limits.

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Jaitley can use an array of fiscal tools against inflation while Rajan has only one blunt instrument called monetary policy at his command - and within monetary policy he has only interest rates as a crude weapon.

Put another way, Jaitley can target his anti-inflation weaponry more precisely at problem areas while Rajan can only bludgeon demand into submission. The finance minister can administer a drug that acts on the body part that is sick without damaging the healthier organs; Rajan only has a broad-spectrum antibiotic that may or may not work on a particular affliction.

Moreover, in a fundamental sense, the argument between government and central bank about interest rates and inflation is pointless for the simple reason that the goalposts aren’t even agreed. The RBI has set itself inflation targets (six percent by January 2016) but the government has not indicated what it is comfortable with. Even today, it can get the RBI to cut rates if it is willing to put a number on relaxing the inflation target.

If Jaitley says he is okay with eight percent inflation by January 2016, Rajan would have less of a problem adjusting rates - though he may argue against setting inflation tolerance levels at such a high level. But like any politician, Jaitley would want to eat his cake and have it too.

He wants low interest rates but will not want to mention an inflation rate for the RBI to target, for fear of setting off a political row if it is too high.

Truth be told, inflation and its future trajectory cannot be predicted in a volatile global and domestic economy where there are so many variables impacting demand and supply - and hence prices. In fact, macroeconomics is more art than science and there is not too much separating it from astrology. So Rajan can argue that inflation is not dead and Bhalla can shake his head in despair over Rajan’s refusal to see reason, but the fact is both could be wrong, both could be right in a limited way, and only hindsight will tell us who is more right or more wrong.

Those who believe that inflation is driven by food prices - about which monetary policy can do little - argue that, therefore, RBI should cut rates. Rajan and Co would argue that this does not quite matter. As long as the headline inflation rates stay high, it is the RBI’s duty to keep pouring cold water on it. If government can’t or won’t do much about food inflation by fiscal and policy reforms, it puts a further burden on the RBI to act tough on inflation. If government’s hands are tied, there is no point in tying the RBI’s hands as well.

If I were Jaitley, I would do the following.

First, I would either confirm or raise the inflation target for the RBI to chase if I want interest rates to be cut soon. I would not advise raising the target but if the political judgment is that higher inflation is more acceptable than slower growth, so be it. Nobody will know which answer is correct till after the event.

Second, no matter what the RBI does, medium term inflation and growth depend more on fiscal policy than monetary policy. This is what Jaitley should focus on instead of letting his ministry officials make a fuss about rates.

Third, what matters to corporates in not just interest rates, but greater access to money and higher returns. They will happily borrow at higher rates if the prospects of returns on projects are higher. This depends on the policy environment more than rates. Also, if the capital markets stay buoyant, big companies can raise equity and borrow less. For smaller companies who have fewer options of tapping the capital market, quick bank recapitalisation and writeoff of bad loans will do more to open the taps than anything else. All these are within Jaitley’s policy ambit.

Fourth, Jaitley should listen more to microeconomists than macroeconomists. Since Indian inflation is largely focused on food items, what he needs is specific advice on how to increase supplies in high-inflation items. This advice is more likely to come from non-fancied microeconomists than macro wizards.

UPA failed on the food inflation front because it could not estime how the sharp increases in growth rates and massive investments in rural areas will shift food demand from cereals to richer food like milk, eggs, meat, pulses, veggies and fruits.

Macroeconomics is too macro to matter when India’s inflation boosters are in niche and specific areas. Rajan’s blunt instruments won’t work here. Jaitley’s precision tools are the ones to use.

Over to you, Mr Jaitley.