Transmission lines

Indian Express, 26 July 2010

The next credit policy announcement will be made on 29th July. RBI is expected to raise interest rates again as inflation did not come down as expected. While food inflation did decline as predicted, the culprit this time is the rise in non-food, non-fuel inflation. This measure of inflation is sometimes referred to as "core" inflation, or the inflation rate that can be impacted by monetary policy and the one that predicts headline inflation. If the decline in food inflation had done the job of bringing inflation down, it might have been sufficient to have blamed inflation on food shortages, the drought and sugar policy, but the rise in non-food, non-fuel inflation is a serious issue. Unless this is brought down there is a danger of kicking off a spiral of inflation.

Addressing the rise in core inflation is not easy. In a more normal context of overheating or rising output demand, and a good transmission mechanism of monetary policy, it could have been argued that monetary tightening was the obvious answer. But when the latest trends in output growth have started faltering and are showing low month-on-month growth (seasonally adjusted), and when the transmission mechanism of monetary policy is weak, rising interest rates will be very unpopular. Further, a small increase in interest rates will not be enough to control inflationary expectations. RBI has been very slowly raising rates by 25 basis points at regular intervals after the crisis. It will have to continue doing so until inflationary expectations decline. It will have to be cautious in the path of monetary tightening as it is likely to cause pain to an economy barely recovering from a recession. However, there is little choice today but to tighten.

Some countries have tried to assure their citizens that inflation will be under control by pegging their exchange rates to, say, the dollar give that the US has low inflation. Many developing countries have used their exchange rate policy to control inflation. But as economies become big exporters and importers and large sums of money flow in and out of the country, it becomes increasingly difficult to peg. This normally results in giving up attempts to manipulate their currencies and then the currency is allowed to float. This means that the currency becomes far more volatile than under the regime when it was pegged. This creates a problem for price stability as prices of goods and services that can be traded move much more, not only with international prices, but also with the exchange rate, both of which are now volatile. These prices also feed into other prices, such as the cost of transport, as raw materials and inputs and into the cost of living. The country now has to create another mechanism to control prices. Inflation control is often done by putting a focus of money and credit supply in the economy on how prices move. When this is done in a formal framework it is known as inflation targeting. It helps anchor monetary policy, or keep expectations of inflation low. Wage negotiations and prices that are often determined by inflationary expectations are influenced by the commitment of the central bank to control inflation. Various mechanisms are put in place to make the commitment credible.

This issue is relevant for India today as the RBI has allowed the rupee to move flexibly for one and a half years now. The question that it now needs to address is that once the rupee is no longer pegged to the dollar what will anchor the rupee? How will people believe that the rupee is not going to lose its value through inflation in the next few years? Why should wage negotiations in 2010 not assume a 10 percent increase in the cost of living for next year? Economic theory offers two choices to the RBI. The first choice is to go back to pegging the rupee to the US dollar. This path appears to have been abandoned as it became increasingly difficult for the RBI to keep the volatility of the rupee dollar rate low. The size of the foreign exchange movements became too large and the amounts needed to manipulate the rupee too large. The distortions it was causing in the economy were too painful.

The second choice for the RBI is to move towards explicitly targeting inflation. To do so it would have to get away from any functions where inflation control may have an explicit conflict with those functions. Debt management of the government and the subsequent responsibility of keeping interest burden of government debt low may be one such function. Currency manipulation in the interest of boosting exports is another such objective from which RBI will have to clearly step away. While any policy that RBI has on monetary objectives will not doubt give a positive weight to output, a weak currency which is unambiously inflationary cannot be a policy objective. Indeed, in India today the exchange rate is the most important channel for transmission of monetary policy. Monetary tightening raises interest rates, these in turn lead to higher capital inflows which make the rupee stronger. A stronger rupee reduces prices of tradables. Keeping the rupee weak prevents price rise control.

Second, to make its commitment to low inflation appear credible, RBI will have to explicitly state which inflation rate (eg Consumer Price Index or Wholesale Price Index) it is targeting so that it can demonstate itself as being willing to be accountable for deviations from the targeted rate. At the moment there is considerable confusion on what is the rate RBI targets. This confusion will have to go and RBI will have to make its commitment clear.

Finally, RBI will have to address all the difficulties that have made the monetary policy transmission mechanism in India weak. Instead of preventing the development of bond, currency and derivatives markets which would have reduced RBI's ability to manipulate the exchange rate, it now needs to turn that policy on its head and take the lead in pushing for financial sector reform. Under the present circumstances RBI may have to raise interest rates by a large amount before interest rates in the market and demand for credit get impacted. But if the RBI is to give India a low and stable inflationary environment in the future, it will have to work hard at improving the monetary policy transmission mechanism thus making a credible commitment to low inflation.

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