On different scales

Indian Express, 17 August 2009

Inflation has risen in recent weeks. Higher food prices are the biggest contributor to this rise. The rise in inflation raises a question on RBI's stance of monetary policy. Should interest rates be raised in response to higher food prices? The weak monsoon is likely to push up further prices of vegetables, dal and rice. Should the RBI respond by tightening monetary policy? I argue below that no amount of raising rates will bring vegetable prices down. Monetary policy, when effective, can impact prices and output 4 to 6 quarters later. The last thing to expect from it is impact on seasonally volatile prices in specific sectors.

The mechanism through which interest rates impact prices is by changing demand. This happens over a long period of many months. Higher real interest rates compress demand. The transmission mechnism of monetary policy takes about one and a half years in coutries like the UK, which have well developed financial markets. In other words, raising interest rates makes investment and consumption more expensive today. This reduces demand for goods and services over the quarters to come, and that leads to reduced pressure on prices.

The question we need to ask before prescribing a tighter monetary policy to control inflation is whether the Indian economy needs a further contraction in demand. Posed like this, the answer to this question should be fairly obvious. Despite the incipient recovery seen in industrial production, the Indian economy continues to face a decline in demand. The last thing it needs is further demand contraction. Even if the world economy picks up and investment sentiment improves, it is likely that external demand (net exports) and private corporate investment will not recover fully in the coming four to six quarters to pre-crisis levels. Further, the weak monsoon will lead to a contraction in rural demand as incomes of farmers and agricultural labourers suffer due to a fall in production. In an economy in which demand has fallen sharply and would remain weak for the coming months, does a policy of further contracting demand through a hike in interest rate make any sense?

The supply shock to food items, due to the weak monsoon, should be met by removing barriers to trade in agricultural goods, both internal and external. It lies in improving infrastructure for fruit and vegetable production, transportation and sales, including cold storage chains, etc. which make sure that higher prices in the market mean higher prices for the farmer. It lies in making sure that farmer has the capacity and the incentive to produce more.

The real interest rate, measured by the nominal interest rate at which companies can borrow minus the inflation relevant for the manufacturing sector, has risen sharply in recent months. While the nominal interest rate have fallen, inflation has fallen far more sharply. India has today amongst the highest interest rates in the world today. RBI should be cutting rates if it looks at forecasted output growth. Instead, RBI Governor D Subbarao is giving signals that he may soon be raising rates. Such a message in an already weak economy will only dampen investment sentiment further. Until June 2009, the data for new investment announcements was very weak. The UPA government II, has failed to announce any serious economic reforms. The combination of the lack of reforms, and high real interest rates has hurt investment sentiment.

The RBI governor argued, in a recent speech, that the RBI should not be an inflation targeting central bank. The problem with this stance is that the country is left completely confused about what the RBI will do next. This only adds to the uncertainty firms face when making investment plans. In the present instance, had the RBI been an inflation targeting central bank, it would have clearly stated its inflation and growth projections and under what scenarios was it necessary to reduce demand further. In such an 'inflation report' it would, in all likelihood, have not said that it needs to reverse its monetary policy easing in the baseline scenario.

Ironically, earlier, in 2006-07, when the economy was overheating, output growth was high and investment rising sharply, inflation targeting would have meant that instead of focussing on keeping net external demand high, by keeping exports cheap and imports expensive, the RBI would have welcomed rupee appreciation. This would have, to some extent, reduced export demand, and increased import demand, thereby reducing net export demand and acting as a dampener to the sharply rising demand. Rupee appreciation would also have reduced profitability of the tradables sector and helped attenuate the investment boom. Further, a rupee appreciation would have, thanks to the exchange rate passthrough, also pulled down prices. Finally, the higher growth in money supply resulting from the purchase of dollars would not have happened at the pace at which it did. This again would have helped in controlling inflation and preventing overheating.

RBI let the rupee dollar rate override all its concerns about inflation when expected inflation was high, and failed to act to prevent overheating. Indeed, it pushed on the agenda of export competitiveness i.e keeping net external demand high. High liquidity and rising inflation kept real interest rates low. And now, when India is witnessing much lower growth, when the economy is weak and when inflation and expected inflation are low, the RBI seems to have swung to the other extreme. This idyosincratic stance follows from RBI's multiple and unclear target approach, such as higher export growth in times of overheating, and now low inflation at a time when the world is going through the worst recession in many decades. This approach creates a state of confusion which damages confidence and investment. This needs to change.

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