Managing Inflation: The RBI Way

Inflation has once again become the headline news.  And the alarm it has raised this time round is understandable; for within a short span it has peaked to a 44-month high of 7.83% against an acceptable/comfortable level of 5%.  The worst part of the current inflation is the rise in the price indices of all categories—primary articles, manufactured goods and fuel—in both year-on-year and week-on-week terms.

Given that, there are experts who consider our Wholesale Price Index (WPI) itself is simply wrong, and they have a point. In their view, WPI is meaningless, for it measures only the prices of goods, while today services account for 55% of our GDP. Secondly, it does not talk about prices at the consumer level, and by the time the Consumer Price Index (CPI) is released, the data becomes obsolete. And here again, they suspect CPI’s ability to truly represent the price situation at the lower strata of the society, incidentally for whom inflation matters the most. Hence, they strongly believe that inflation anywhere above 5.5% is in itself a threatening phenomenon for those in low-brackets of income.

As if it is the right time, rupee too has started falling at this very hour of rising inflation and depreciated by 6% since April 15, making the fiscal measures—such as cutting import duties on edible oils and maize, banning export of pulses and non-basmati rice, withdrawal of export incentives for steel and cement, and other questionable measures including banning futures trading in certain agricultural commodities, threatening to add steel to the list of its ‘essential commodities’, etc.—initiated by the government less effective in arresting prices. Looking at the all round surge in prices, the emerging global food crisis, the rising oil-prices and falling rupee, one is more tempted to infer that prices will not come down in the immediate future; and no wonder, if on the other hand, inflation peaks to 8% soon. Cumulatively, all these developments have made the job of Reserve Bank of India (RBI) more daunting. Striking a right balance between price control and growth is always a big challenge, particularly for a central bank of a developing country, since there is always a cost behind controlling inflation.  No matter whether one follows Keynesians or monetarists, as inflation is generally controlled by pursuing contractionary policies, it results in reduced output, employment and income.  

   

It is against this backdrop that the RBI, as a policy response, has raised Cash Reserve Ratio (CRR) by another 25 basis points to 8.25%—the third increase in the last three weeks  to contain liquidity. Contrary to the general expectation, the RBI has, of course, more sensibly retained its benchmark interest rate at 7.75%. This balancing act of the RBI— maintaining the growth momentum and inflationary expectations by opting for CRR hike alone—might  have surprised many, particularly those monetarists who strongly believe in what Milton Friedman said: “Inflation is always a monetary phenomenon.” What Friedman meant here is that when the price for wheat rises, a consumer would spend more on acquiring wheat, and his ability to spend on other items such as, say, TV or fridge becomes less, and hence their prices fall. He therefore concludes that money determines the overall price level of an economy, but not of any one good. Therefore, monetarists proclaim that in the long run, inflation is a monetary phenomenon and inflation arises when the money supply expands more rapidly than output. They indeed consider the quantity of money as an ‘exogenous’ variable, by which they mean that money growth is an independent causal variable defining the rate of inflation. In other words, inflation, according to monetarists, flows from money in the form of excesses demand—excess of aggregate demand over aggregate supply—that raises prices, but not the other way round.

But looking at the Indian experiences —outbreak of major droughts often resulting in skyrocketing prices of food items leading to hunger and malnutrition in the rural areas—one wonders if inflation is always a monetary phenomenon. Friedman’s statement—for a given quantum of money supply, a rise in the price of an item, say, for instance rice, is offset by a fall in the price of another good, say, television—may be an apt reflection of price behavior in rich economies such as the US, but is less likely to hold good for India since food items alone constitute roughly 80% of the budget of almost 60% of the population. Secondly, our WPI allocates lesser weight to food items, as today agriculture hardly accounts for 20% of GDP. In the light of these ground realities, we cannot presume that inflation is always a monetary phenomenon. 

Against the backdrop of the demand-supply mismatches across the domestic and global markets, the RBI’s decision not to raise interest rates sounds pretty rational and sound. In such a situation, mere monetary tightening will be of little use in controlling the inflation. The solution for the current rise in prices therefore lies not in short-term monetary policy, but obviously elsewhere: long-term efforts are essential to mitigate the supply-side constraints under food-grains. It must make long-term investments for improving agricultural productivity, energy-efficiency and transport infrastructure in the country.

Economics, however, says that today’s increased prices must induce greater production tomorrow. But in capital-starved developing economies, such adjustments are sure to take a long time to happen on their own, and that is where governmental intervention is warranted to ensure growth—the right answer for our inflationary woes.

(June, 2008)