The percentage game
Indian Express, 20 June 2011
The RBI credit policy continued with its anti-inflationary stance raising interest rates, and indicated that controlling inflation would be its priority. For a central bank to be able to prevent price shocks from becoming persistent inflation, its policy strategy has to go beyond episodic rate hikes to a full-blown strategy of commitment, communication and consistency.
While most people expected the rate hike, considering the increase in inflation as seen in the most recent data, others, such as industry lobbies, objected to the rate hike. It is argued that when inflation is being caused by factors that the central bank has no control over, such as food prices, global commodity price shocks or a large fiscal deficit, there is no role for monetary policy.
It is true that the central bank cannot control an increase in onion prices if the harvest fails, and shocks to inflation will continue to be caused by such difficulties. The only thing monetary policy can do in this situation is to control the medium or long run inflation rate. It can ensure that owing to a credible commitment to a low inflation rate in the medium term, the rise in inflation owing to an episodic food price shock is seen by the public as a one time temporary increase in inflation. That way it will not feed into inflationary expectations, into wage bargains and cost of production, and hence become generalised.
Inflation is the increase in prices in this period compared to the last period. All countries face global commodity price shocks and have fairly irresponsible governments. Price shocks and fiscal deficits create bouts of inflation. The difference is that in some countries, each shock creates a sharp increase in prices, or temporary inflation, which then subsides away. In others, the shocks seem to result in stubborn and persistent inflation. Whether we fall into one case or the other depends entirely upon monetary policy strategy.
Monetary policy cannot control price shocks and the inflation it causes, but it can control inflation persistence. However, this control is a complex and time taking process. It does not happen merely by hiking interest rates. It happens by communicating to the public that the central bank is committed to inflation control. If the central bank's commitment is credible, and the public believe that the central bank will do what it takes to bring inflation under control, temporary inflation will not feed into wages and price-setting. The inflation rate would go down once the effect of the shock is over. This is the reason why central banks worldwide promise an inflation target. The public understands that the central bank does not control the price shocks but believes that once the shock is over, the inflation rate will come back to target levels.
The second concern about hiking rates is that the RBI should be mindful of the slowdown in output. Here the argument is based on the grounds that in Inda today, investment has slowed. Interest costs form part of the decision to invest. It is, then, feared that rising interest costs will further hinder investment and output growth. However, interest payments are only a small component of investment. Expectations of higher growth, certainty about the policy enviroment and good governance are some of the other important elements that feed into it. Interest rates have been low all over the world. Real interest rates, measured as nominal interest rates adjusted for inflation, have been low in India as well. However, neither in the world nor in India have these low interest rates pushed investment rates up. The low rates were intended to help keep consumer demand high to offset the effects of the recession. Once the worst of the recesssion fears were over, it was time to bring interest rates back up. We erred in letting them remain low for too long.
What is the role of monetary policy in growth? The central bank tries to minimise output volatility. However, in the case of inflation, central banks have a much more direct impact given their integral role in fiat money. In the case of output, the long run growth rate of output in a country depends on productivity growth which comes from growth in labour, capital and total factor productivity. Merely doing things better, organising and managing them differently, or improvements in technology can increase total factor productivity. The best thing that central banks can do, to foster long-term growth in the country, is to deliver low price volatility, which helps the private sector plan for the future in greater confidence.
Can output volatility be reduced by specifically targeting output growth? Should the RBI not be looking at trying to increase output growth in India today? Central banks usually focus on inflation rather than output for a number of reasons. Traditionally, the Taylor rule for monetary policy puts a positive weight on output gap. The output gap is supposed to measure the difference between the present level of output and potential output. It is, however, very difficult to measure potential output. At any point of time, given the time lags in data, it is also difficult to measure actual output. Second, a specific focus on output makes communication with the public much harder. A discussion about how much is the output gap and what is the weight being given to it by the central bank has the danger of making the public question the central bank's commitment to inflation control and believe that if output falls far enough, the central bank may turn its focus to it and allow inflation to rise. This again has the danger of allowing inflationary expectations to rise.
We have now seen ten rate hikes by the RBI in the present interest rate cycle. It is striking that despite the rate hikes, there has been an increase in inflationary expectations. This points towards the need for RBI to build credibility about its inflation control. Currently RBI is saddled with a number of other functions. In the medium terms, these conflicts of interest need to be removed, but in the short run it is not possible to improve RBI's credibility through this process. Hence, in the short run, the full power of RBI communication must focus on inflation control as its mantra. If RBI could succeed in doing that under C. Rangarajan's governorship, surely today's RBI can try too as well.
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