Is Rajan trying to do what Paul Volcker did in the US ?

Going against market expectations Raghuram Rajan, the governor of the Reserve Bank of India(RBI), raised the repo rate yesterday by 25 basis points (one basis point is one hundreth of a percentage) to 7.5%. Repo rate is the interest rate at which RBI lends to banks.

It was widely expected that Rajan will cut the repo rate. But that did not turn out to be the case. In his statement Rajan explained that he was worried about inflation. As he said “recognizing that inflationary pressures are mounting and determined to establish a nominal anchor which will allow us to preserve the internal value of the rupee, we have raised the repo rate by 25 basis points.”

The RBI’s Mid-Quarter Monetary Policy Review echoed a similar sentiment. “What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence. Although better prospects of a robust kharif harvest will lead to some moderation in CPI inflation, there is no room for complacency,” the statement pointed out.

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Rajan, as I explained yesterday , believes in first controlling inflation, instead of being all over the place and trying to do too many things at once. As Rajan wrote in a 2008 article (along with Eswar Prasad) “The RBI already has a medium-term inflation objective of 5 per cent…But the central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”

[caption id=“attachment_1124741” align=“alignleft” width=“380”]  Reuters[/caption]

And given this the RBI ends up being neither here nor there. As Rajan put it “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”

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Hence, Rajan felt that the RBI should ‘just’focus on controlling inflation. As he wrote in the 2008 Report of the Committee on Financial Sector Reforms “The RBI can best serve the cause of growth by focusing on controlling inflation and intervening in currency markets only to limit excessive volatility…an exchange rate that reflects fundamentals tends not to move sharply, and serves the cause of stability.”

Given this, Rajan’s strategy seems to be similar to what Paul Volcker did, as the Chairman of the Federal Reserve, to kill inflation in the United States, in the late 1970s and early 1980s. On August 6,1979, Volcker took over as the Chairman of the Federal Reserve of United States .

When Volcker took office, things were looking bad for the United States on the inflation front. The rate of inflation was at 12%. In fact, the inflation in the United States had steadily been going up over the years. Between 1964 and 1968, the inflation had averaged 2.6% per year. This had almost doubled to 5% over the next five years i.e. 1969 to 1973. And it had increased to 8%, for the period between 1973 and 1978. In the first nine months of 1979, inflation had averaged at 10.75%. Such high inflation during a period of peace had not been experienced before.

As inflation was high people bought gold. On August 6, 1979, the day Volcker had started with his new job, the price of gold had stood at $282.7 per ounce. On August 31, 1979, gold was at $315.1 per ounce. By the end of September 1979, gold was quoting at $397.25 per ounce having gone up by 26% in almost one month.

On January 21, 1980, five and a half months after Volcker had taken over as the Chairman of the Federal Reserve of United States, the price of gold touched a then all time high of $850 per ounce.

In a period of five and a half months, the price of gold, had risen by an astonishing 200%. What was looked at as a mania for buying gold was essentially a mass decision to get out of the dollar. Given this, lack of stability of the dollar, Volcker had to act fast.

After he took over, the first meeting of the Federal Open Market Committee (FOMC) was held on August 14,1979. FOMC is a committee within the Federal Reserve, the American central bank, which decides on the interest rate. The members of the committee expressed concern about inflation but they seemed uncertain on how to address it.

In September 1979, the FOMC raised interest rates. But it was split vote of 4:3 within the seven member committee, with Volcker casting a vote in favour of raising interest rates. Volcker clearly wasn’t going to sit around doing nothing and came out all guns blazing to kill inflation, which by March 1980 had touched a high of 15%. He kept increasing the interest rate till it had touched 20% by January 1981. This had an impact on inflation and it fell to below 10% in May and June 1981.

The prime lending rate or the rate, at which banks lend to their best customers, had been greater than 20% for most of 1981.

Increasing interest rates did have a negative impact on economic growth and led to a recession. In 1982, unemployment rate crossed 10%, the highest it had reached since 1940 and nearly 12 million Americans lost their jobs. During the course of the same year nearly 66,000 companies filed for bankruptcy, which was the highest since the Great Depression. And between 1981 and 1983, the economy lost $570 billion of output. But the inflation was finally brought under control. By July 1982, it had more than halved from its high of 15% in March 1980. The steps taken by Paul Volcker ensured that the inflation fell to 3.2% by 1983.

By continuously raising interest rates, Volcker finally managed to kill inflation. This ensured that the confidence in the dollar also came back. By doing what he did Volcker established was that he was an independent man and was unlike the previous Chairmen of the Federal Reserve, who largely did what the President wanted them to do.

In fact, when Arthur Burns was appointed as the Chairman of the Federal Reserve on January 30, 1970, Richard Nixon, the President of United States, had remarked that “I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed.”

The feeling in the political class of India is along similar lines. The finance minister expects the governor of the RBI to bat for the government. But that hasn’t turned out to the case. The last few RBI governors (YV Reddy, D Subbarao) have clearly had a mind of their own. And Raghuram Rajan is no different on this front. His decision to raise interest rates in order to rein inflation is a clear signal of that.

But the question is can the RBI do much when it comes to controlling consumer price inflation(CPI)? Can Rajan like Volcker did, bring inflation under control by raising interest rates? Or can he just keep sending signals to the government by raising interest rates to get its house in order, so that inflation can be brought under control?

In India, much of the consumer price inflation is due to food inflation, which currently stands at 18.8%. While overall food prices have risen by 18.8%, vegetable prices have risen by 78% over the last one year. As a discussion paper titled Taming Food Inflation in India released by Commission for Agricultural Costs and Prices (CACP) in April 2013 points out, “Food inflation in India has been a major challenge to policy makers, more so during recent years when it has averaged 10% during 2008-09 to December 2012. Given that an average household in India still spends almost half of its expenditure on food, and poor around 60 percent (NSSO, 2011), and that poor cannot easily hedge against inflation, high food inflation inflicts a strong ‘hidden tax’ on the poor…In the last five years, post 2008, food inflation contributed to over 41% to the overall inflation in the country.”

The government procures rice and wheat from farmers all over the country at assured prices referred to as the minimum support price. This gives an incentive to farmers to produce more rice and wheat for which they have an assured customer, vis a vis vegetables.

As a discussion paper titled National Food Security Bill: Challenges and Options released by CACP points out “Assured procurement gives an incentive for farmers to produce cereals rather than diversify the production-basket…Vegetable production too may be affected - pushing food inflation further.”

There is not much that the RBI can do about this. As Sonal Varma of Nomura Securities puts it in a report titled India: RBI Policy - A Regime Shift “Inflationary expectations are elevated primarily due to supply-side driven food inflation. In the absence of a supply-side response, severe demand destruction may become necessary to lower inflationary expectations.”

Hence, it remains to be seen how successful the Rajan led RBI will be at controlling inflation.

(Vivek Kaul is a writer. He tweets @kaul_vivek)