India
gives ground on inflation
targeting By Kunal Kumar Kundu
BANGALORE - Reserve Bank of India governor
Duvvuri Subbarao, having let go of the bank's
inexplicable fetish for limiting interest rate
increases to 25 basis points, now claims that
inflation targeting is neither feasible nor
advisable in India.
The bank last week
increased its benchmark interest rates by 50 basis
points. It increased the repo rate, the rate at
which the RBI provides credit to banks, to 7.25%
(up from 6.75%) and the reverse repo rate, the
rate at which banks park funds with the RBI, to
6.25%. The cash reserve ratio for banks was
unchanged and the savings banks deposit rate
increased to 4% from 3.5%.
Subbarao, in a
speech posted on the RBI's website, said "... In
an emerging economy like ours, it is not practical
for the central
bank to focus exclusively on
inflation oblivious of the larger development
context ... The Reserve Bank cannot escape from
the difficult challenge of weighing the
growth-inflation trade off in determining its
monetary policy stance."
Is this a subtle
hint at a shift in policy focus from a stated
primary objective of combating inflation? Or a way
to deflect blame for the bank's inability to read
the economic conditions correctly and hence to
gauge inflation?
The RBI (let alone
government officials) has not covered itself with
glory in its estimation as to where inflation is
headed. Since the middle of the fiscal year that
ended in March 2010, the stated official line was
that the year would end with 5% inflation. It
ended with a rate at more than double that figure.
The predictive failure of the collective
wisdom, rather than leading to a change in
forecast, led to an even more determined emphasis
on year-end inflation (this time for the year to
March 2011) of 5.5%. Confidence in the forecast
stemmed from two factors - one statistical (a high
base effect) and the other fortuitous (a better
monsoon and hence a good harvest).
Yet
fiscal 2011 ended with inflation at a little less
than 9%. This can actually be revised upwards,
given that the January inflation number has been
revised upwards from 8.2% to 9.4% (an increase of
a considerable 120 basis points). Some
improvement!
Inflation is not always a
monetary phenomenon. Monetary policy can hardly
(if at all) play an important role in stemming
food inflation. Also, given its inherent
structural deficits, the Indian economy is prone
to bouts of high inflation whenever there are a
few consecutive years of high and solid growth.
Clearly these are governance failures, and there
is not much a central bank can do in such
circumstances.
The RBI, however, can gain
solace from the fact that central banks the world
over have not been notably successful in taming
the inflationary demon. Additionally, the RBI
lacks formal independence and this makes its task
difficult as politics quite often end up playing
an important role.
This does not absolve
the RBI for its failure. Expectations play an
equally important role on determining direction.
Even with a current repo rate at 7.25%, the real
interest rate in India continues to be negative
and it has been persistently so for a fairly long
period. This is a bad policy response, and India
cannot but face the consequences of such folly.
In a high-inflation scenario, the baby
steps in the rate hike cycle lead to front loading
of demand (especially leveraged demand) to beat
the rising future rates, thereby fueling
inflationary pressure. With the external
environment turning adverse, the inflation genie
is well and truly out of the bag. Persistently
high food and other commodity prices have resulted
in high headline inflation percolating to core
inflation through a wage price spiral.
One
is not surprised, therefore, to see that the RBI
has suddenly started to believe that there is a
growth-inflation trade-off while earlier they were
not so convinced.
The highly accommodative
(read persistently negative real rate) monetary
policy has failed to push gross domestic product
(GDP) growth to a higher orbit. Indeed, the Indian
economy is showing signs of slowdown, with a clear
slowdown in the index of industrial production.
Demand for capital goods has been falling. Growth
in real imports, discounting for higher commodity
prices, remains low, indicating weakening demand.
The trade-off is very clear.
While this
way the RBI can feel that it is morally correct,
ask Indian consumers how they feel. According to a
recent survey (titled "If middle class people are
suffering so much due to inflation, what about
poor and below poverty line citizens?") by The
Associated Chambers of Commerce and Industry of
India, household savings of an average employee in
the metropolitan areas have come down by 45% in
the past six years due to exorbitant increases in
the prices of essential commodities, fuel,
education, housing loan payments and increases in
health insurance premiums. The standard of living
is now a quarter less than what it was in 2006.
Releasing the findings of the survey,
secretary general D S Rawat said, "In an average
salary structure of Rs 40,000 [US$894) per month,
the amount available for discretionary spending is
not more than Rs 17,000 as [the] average employee
shells out over Rs 6,000-8,000 on housing loan or
rent, 5,000 loan on cars, two-wheelers,
7,000-10,000 on education cost and FMCG
[fast-moving consumer goods]. The share of
insurance premia, including health insurance is
over Rs 3,000-5,000 each month as employees need
to ensure [sic] themselves including their
families as there is no social security net in
it."
In such a situation, what indeed is
the plight of the poor? I have always been a
votary of consistent (even if a relatively low)
level of growth with low inflation rather than
spurts of high growth with high inflation that
squeezes out the poor.
India's
inexplicable policy has resulted in GDP growth
showing signs of a slowdown, but inflation is not
slowing down as desired - unless the global
environment suddenly changes. Policymaking in
India, it seems, factors in a large dose of luck
when it seeks to achieve a stated objective.
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