RBI is shooting itself in the foot over inflation

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 (Consumer Price Index for Industrial Workers). 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.

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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 (the Whilesale Prices Index) and explain away inflation by saying “but it’s only concentrated in a few things which make up X percent 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.

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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 3 May, Dr Subbarao (the Reserve Ban Governor) 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 the RBI was starting to take the inflation crisis seriously. And that was good. Also see an Indian Express column by Ila Patnaik on 6 May.

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 (year-on-year) changes of the CPI-IW back to the target zone of four to five percent”. And the rate is hiked by 25 bps (100 bps make 1 percent). 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 (on housing loans), 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, the RBI has imposed more of the heavy lifting upon the former.

What does it take for the 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 debt management office (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, the RBI is generating a situation where there is no commitment that in the future, it will fight inflation.

Whether the 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 percent 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, the 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.

Source: Ajay Shah's Blog