Four per cent tips

Indian Express, 11 November 2006

Finance Minister P.Chimdambaram has said that India should target a 4 percent inflation rate. In recent months there has been a sharp rise in prices, measured by the Consumer Price Index (CPI) to beyond 6.5 percent. Pulling down the inflation rate, and then following policies that keep inflation at this target needs a clear framework. How should the government keep prices from rising at rates above 4 percent per annum?

Under the old socialist India when the economic model for the country was control of quanties and prices by the administration, the government would bring down prices by setting the prices of cement, steel, sugar etc. These commodities would then be rationed because the controlled price would mean there would be excess demand at the price. Black market prices would be even higher than what market prices might have been. After the collape of the Soviet economy, and market oriented reforms in India in 1991, it was understood that this was not the most efficient way of controlling price rise in a country.

The most important aspect in which a market economy differs from a socialist economy is in the way prices are determined. Some of the remanants of the socialist model still remain with us. The sale of wheat, rice, kerosene through PDS shops, the fixing of oil prices by the government, the setting of the savings account interest rate by the RBI and the fixing of interest rate of provident fund by the government are a few examples. The next level of intervention in specific markets is when the government does not fix prices, but tries other ways of manipulating the price of a particular commodity by lifting import restrictions or by preventing exports, or by changing import duties. However, these measures also address the issue of price rise through admininstrative handles, often in markets for particular commodities that are highly politicised.

In contrast, mature market economies often target the inflation rate based on broad price indices rather than the price of a few commodities. There are at least 22 countries, mainly rich industrial countries, where an inflation rate is targeted. The main difference in terms of the framework that India has had until recently and OECD countries is that in market economies inflation is understood to be a macroeconomic phenomenon and price control is implemented not through price controls and rations, except during a war or an emergency, but through macro economic policy.

Theoretically, both fiscal and monetary policy can be used by the government to target inflation. However, it has been found that the use of fiscal policy, which involves tax rates and public spending is not a very effective tool in the hands of governments. If prices are rising, fiscal policy would need tightening. This would imply raising tax rates and cutting government spending. First, this is politically very difficult to do for an elected representative such as a minister as it is unpopular. And, second, it cannot be done easily in the middle of the year when the budget is a few months away.

In contrast, monetary policy, that primarily involves raising or lowering the interest rate at which the central bank lends money to commercial banks, has been found to be a more effective instrument in most countries that target an inflation rate. The raising of interest rates, by a few percentage points, is not as unpopular as raising taxes and cutting say speding on health or education. Moreover, governments have found ways of reducing the element of unpolarity and political difficulty associated with tighter monetary policy by putting this responsibility in the hands of central banks who have been given the task of inflation targeting. Second, changes in monetary policy can be brought about at any time during the year. In India, the RBI has moved from half yearly to quarterly monetary policy announcements, but changes in interest rates have been announced even between the two quarterly policy announcements. In UK and US regular meetings by the monetary policy committee discuss the question of interest rate hikes or cuts.

When the central banks makes it more expensive for commercial banks to borrow from it, it makes it more expensive for them to lend and this is supposed to pull credit growth down. Often the changes are very small and one might wonder whether such small changes will have an impact on credit growth, demand for goods in the market and thus their prices. Strangely enough, as a significant amount of research in the field now shows, in countries in which central banks target inflation, this policy actually seems to work. The way it is often done, for example in the UK, is for the government to specify an inflation target which is then conveyed to the central bank. The one and only dharma of the central bank is to meet this target. When it changes interest rates in response to inflation data, it impacts expectations of market participants and through it their investment and consumption behaviour and ultimately prices.

India has not had an explicit inflation target until now. The government has not given the RBI the responsibility to meet one. The RBI has not set one for itself. RBI's reports have often talked about a 5 to 6 percent inflation rate as the "expected" (not targeted) inflation for the following year. Chidambaram's call for a 4 percent inflation target is a welcome development. The next step should be to institutionalise this framework. This should be done sooner rather than later. This will have three advantages. First, targeting inflation often means increasing interest rates. Since the central bank is not an elected body it can afford to take these politically unsavoury decisions, while the parliament which is an elected body, only takes the more popular decision of keeping the inflation rate low. Second, it takes a while for monetary policy to have impact on prices. In other words, interest rate hikes done now will have an impact over the next one to two years. It might take a few hikes before inflation can be brought down before the next election. Chidambaram should be seen as pressing RBI for bringing inflation down, instead of being seen as the man responsible for higher interest rates. Third, making monetary policy explicitly responsible for inflation will help change the public mindset that demands micro-management of markets through administrative changes. Hopefully oil and wheat prices will stop being political decisions.

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