Rates of little return

Indian Express, 18 March 2010

The sharp rise in inflation to 10 percent is a cause for concern. Headline inflation will get worse for a few weeks and then it will decline. Policy makers have to keep that in mind before raising interest rates. RBI's policy mix is mostly on the right track.

Inflation remains a worry as the consumer price index is continuing to rise. On a month-on-month, seasonally adjusted basis, the consumer price index (CPI) for industrial workers rose at an annualised rate of 20 percent in January. It suggests that when the year-on-year data comes out, which is what we usually look at in India, the numbers will worsen.

At the same time, the story on inflation is largely positive. After a sharp increase in food prices from June to December 2009, food inflation, measured on a month-on-month basis with seasonal adjustment, has dropped to nearly zero. When volatile fluctuations of food and fuel prices are removed from the reckoning, we are left with WPI Manufacturing, which is hovering around 5 percent.

Inflation watching in India is done largely using year-on-year inflation. This picks up current developments on inflation with a lag of roughly six months. Hence, even though the latest information (month on month, seasonally adjusted) is showing an improvement, for the coming six months, the year-on-year information is going to show high inflation. This will put pressure on RBI to raise interest rates.

RBI is a highly non-transparent central bank. RBI communication does not reveal the full picture, and considerable analysis is required to unearth what is going on. In recent months, RBI has apparently done little (other than raising the CRR in January). At the same time, a deeper analysis shows a significant monetary tightening that has been taking place without announcement.

Money supply growth is an important indicator of monetary conditions. This has come down from levels of more than 21 percent in July 2009 to nearly 16 percent in February 2010. Traditionally, reserve money grew because RBI was focused on the exchange rate and continually buying dollars. From 26 March 2007 onwards, RBI's behaviour on the currency market has shifted towards greater exchange rate flexibility. In the last year, RBI's purchase of foreign exchange has dropped to near-zero levels. Under this flexible exchange rate regime, the rupee has appreciated from Rs.50 to Rs.45.50. This shift in RBI's behaviour has reduced the pace of injection of rupees into the economy. Another element of the story is low demand for credit, giving slow growth in non-food credit. Putting these elements together, money supply growth has deccelerated sharply over 6 months.

In addition to domestic monetary conditions, the major determinants of inflation in an open economy are exchange rates and world prices. With an improvement in the US economy, global prices are picking up. If the exchange rate remains broadly unchanged, the rise in world prices will be passed-through to a rise in domestic prices in India. A rupee depreciation would have the same effect. The 5 percent inflation rate in WPI-manufacturing reflects this combination of world prices and exchange rate movements.

Despite the decceleration in month-on-month inflation in the last two months, and the coming harvest which might lower food prices further, RBI will need a sophisticated approach to inflation. It will primarily have to look at world prices and be concerned about potential rupee depreciation. When faced with inflationary pressure, policies which strengthen the rupee will help.

One channel for this is hiking interest rates. When the domestic interest rate is raised, more capital comes into the country, resulting in a rupee appreciation. The second option is to liberalise capital controls. Removing the barriers against foreign investment in the rupee-denominated bond market would kill many birds with one stone: it would combat inflation, along with providing better financing for domestic industry and infrastructure projects.

In summary, there are two important mistakes in the Indian inflation discourse. The first is the use of year-on-year inflation measurement, which yields information about inflation pressures in the economy with a lag of roughly six months. The second is the notion that RBI can influence inflation by raising rates. What mainstream central banks worldwide can do -- given a well functioning bond market and banking system -- is not feasible for RBI given the crippled bond market and banking system. Mechanically raising rates when inflation goes up is not particularly useful, given the malfunctioning monetary policy transmission.

A more nuanced approach, reflecting an empirical understanding of relationships visible in Indian data, is required. RBI's communications on this subject need to improve, combining a better analytical framework, and an honest treatment of its trading activities on the currency market. Thus for example, if the RBI chooses not to raise interest rates, as they are unlikely have a direct impact on inflation, it should say so clearly, and explain why, describe how a quiet tightening has been taking place and what policy options are being chosen and why. Not doing so results, in general, in a situation like the present one where expectations of rate hikes build up, and RBI comes under pressure from various quarters on its conduct of monetary policy.

Opposition parties have been raising a storm over inflation. The government and the RBI do not have adequate levers in their hands to control inflation. The most important instrument, the short term interest rate that has worked in many other countries, does not work in India due to a lack of financial sector reforms. This inflation episode serves to highlight this problem caused by difficulties in the monetary policy transmission mechanism. The RBI and the government should actively focus on building financial markets and increasing financial inclusion that would make short term interest rates an effective instrument of monetary policy.

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