Not by rate hikes alone
Indian Express, 27 April 2011
Inflation continues to persist and pose a problem even though food inflation has declined. For nearly two years RBI's stance on inflation was that food inflation is caused by supply side constraints, and the RBI could not, and should not, do anything about it. The result of that policy has been high inflationary expectations and persistent inflation. Today when world crude oil prices are rising, what should RBI's policy be? Should it again take the stance that there is nothing the RBI can do about world commodity prices and hence monetary policy need not respond?
One of the obvious difficulties India has is the lack of demand adjustment for petroleum products. When petrol and fertiliser prices are not raised commensurate with increases in the world crude oil prices, demand for petrol and fertilisers does not fall. In general, in most countries, while demand for petroleum products is inelastic in the short run, in the long run this demand is more elastic and the consumption of oil falls. This results in a lower demand for oil and keeps the current account deficit in check. In India, because we do not raise petrol and fertiliser prices, the demand for petrol and fertilisers does not decline and we end up with a large import bill. All other things remaining equal, this would result in a depreciation of the rupee. A weaker rupee then implies higher prices of all tradable goods. More expensive raw materials and machines then push up the cost of production of all goods in the market.
By not increasing the price of petrol and fertilisers, the burden of higher prices shifts from the users of petrol and fertilisers to the general population. This consequence is the contrary to what the government says it is trying to do, i.e. control inflation by not raising petrol and fertiliser prices. The political economy is fairly staightforward. Petrol consumers are middle class, vocal and loud. The somewhat adminstered nature of the price petrol, even after the deregulation, makes a rise in petrol prices a political issue. Fertiliser using farmers organise votes and rallies. In effect, the burden of adjusting consumption downwards shifts from the vocal urban middle class or rich farmers to the rest of the population.
How should monetary policy respond? The above analysis suggests that the lack of adjustment of petroleum product prices is likely to lead to an increase in all tradable prices. Alternatively, if petroleum product prices are raised after the state elections are over, they would contribute to a rise in the overall prices level. Petroleum product prices matter directly since they go into the CPI. CMIE household survey data for 2009-10 shows that 7.31 percent of household consumption is expended on petrol, diesel and cooking fuel.
The RBI could respond to the expected increase in inflation by doing nothing as petrol prices are driven by world demand and supply conditions, an argument similar to the one the RBI make on food inflation where it expects protein prices to continue rising due to higher per capita GDP growth. Alternatively, the RBI can tighten monetary policy in line with the increase in inflationary expectations. This would push the burden of adjustment to investment and consumption and the economy as a whole. However, when faced with high inflation and rising world crude oil prices the RBI has little choice but to tighten monetary policy.
Tighter monetary policy has two difficulties at present. One, private corporate investment has not really picked up after the crisis. While projects under implementation continued to be taken to completion, the pipeline of new projects announced has fallen sharply. As a consequence, in the coming two to three years investment activity make be expected to slow down considerably. Second, the government has a large borrowing program. Higher interest rates will push up the cost of government borrowing. This will increase government interest payment expenses further.
The current pricing policy of petroleum products and fertilisers will not only reduce the real incomes of consumers in general, it will also create serious problems for the fiscal deficit. The price rise has been larger than what appears to have been assumed in the budget for 2011-12, with no signs at present of any downward movement. If the entire increase is absorbed as subsidy then some estimates suggest that the subsidy bill may rise by 2 percent of GDP. This would make the fiscal deficit much worse than what the Budget projections indicated.
While monetary policy has a role in curbing inflation and inflationary expectations, the distortions introduced by administered prices of petroleum produts and fertilisers make the job of the Governor much harder. Not only will rate hikes need to be sharper and more frequent, their effectiveness may be limited as well. In its communication strategy, the RBI should discuss these difficulites openly and prepare market participants about the actions it may need to take. Considering the strong political economy reasons why petroleum product and fertiliser prices decontrol may not happen very soon (even if there is some adjustment in the prices after the elections), the RBI needs to re-assess its strategy on how monetary policy in India responds to these situations. That would be a more tenable position compared to the present one.
Further, instead of junking the strategy of focussing on inflation, the RBI needs to look at recent research that shows that contrary to popular belief, a hard look at the data suggests that inflation targeting countries did better in the great recession on counts of both output and employment compared to those that did not target inflation. Persistent and moderately high inflation in India should be enough of a trigger for RBI to review its monetary policy framework.
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