Reserve Bank, refocus

Indian Express, 28 December 2011

When the world economy faced a crisis in 2008, India prided itself on escaping relatively unhurt. Now that the Indian economy is slowing down, owing to both the impact of the global slowdown and uncertainty, and the policy framework in the domestic economy, a part of the blame is being put on monetary policy. It is claimed that monetary policy is excessively tight and has caused the decline in investment. It is further argued that a cut in interest rates will solve the problems of the Indian economy and push up growth.

There are two problems with this argument. First, it is important to point out that even though RBI increased interest rates 13 times, most of these were small hikes and they did not push rates to positive real values. Ask a retired teacher living off interest income on her lifetime savings if she is richer than she was a year ago when both inflation and interest rates were lower. A real increase in interest rates has occurred only if she can buy more today than she could last year. This is not the case.

Second, there is a lesson in the history of monetary policy that is pertinent to India today and that this argument is ignoring. The idea that a central bank has a choice between driving up output versus fighting inflation originated with Alban William Phillips in 1958. He found a regularity in the data - that high inflation periods tended to be high growth periods. And for a while, this idea guided US monetary policy. From 1960 to 1969, it worked well. But after 1969, inflation in the US rose and growth fell. In 1973 an oil shock hit prices. The Fed did not tighten monetary policy saying that it was a supply side phenomenon, and so did not matter for monetary policy. Unfortunately, they were wrong. By 1974, US unemployment was up to 9 per cent and at the same time, inflation was above 12 per cent.

The US was trapped in `stagflation' - the blight of low growth and high inflation at the same time. The existing policy framework did not know how to cope with such a phenomenon. In desperation, Richard Nixon once ordered a 90-day ban on all increases of prices and wages. It was thought that this would stop the inflation. But it did not.

The solution lay in a rethink of the role of monetary policy. Evidence suggested that there was no trade off between inflation and growth in the long run. New emphasis was laid on the role inflationary expectations. Once households and firms expect high inflation, they build this into their calculation, and this inflation becomes very hard to wring out of the system.

The new thinking was put to work by Paul Volcker, who became Fed chairman in 1979. The US Fed has a legal mandate to pursue both growth and employment. From Volcker's time onwards, all Fed chairmen have argued that the best thing that the Fed can do for having high employment is to deliver low and stable inflation. Hence, the primary goal of the Fed, at a practical level, has become low and stable inflation.

US inflation was at 10% in 1979 and soared to 14% in 1980. This is similar to India's situation in 2011 and potentially 2012. By the time he stepped down, in 1985, inflation was down to 2%, and the US economy was on the path to an economic expansion.

In the last two decades there has been a fundamental transformation of monetary policy frameworks in many countries. Many central banks are now "inflation targeting central banks", which means that the main job of the central bank is to deliver low and stable inflation. In forecasing inflation the central bank does consider the performance of output, but it does not claim that monetary policy can give an economy high growth.

Turning to India today, we have a macroeconomic slowdown with low investment coupled with high inflation. Stagflation for India is when growth is below the rate at which we can gainfully employ the young men and women entering the labour market. This may even be a 5 percent rate of GDP growth and is comparable to economies in Europe who face zero growth.

It is important to see that the high and volatile inflation in India is, in itself, a major problem that is holding back investment. Our macroeconomic instability is frightening the private sector, which is then loath to invest, and particularly loath to invest in long-term projects. When a CEO in India examines a spreadsheet with forecasts for the next decade, he has little confidence for what prices and interest rates will look like in coming years.

The best contribution that monetary policy in India can make towards achieving high growth is delivering low and stable inflation: of achieving year-on-year CPI inflation in the range from 4 to 5 per cent. This should be consistently achieved, month after month, year after year. RBI should be held accountable for achieving this target. The governor should have to explain to Parliament and the public when inflation misbehaves.

The closest we have to a Paul Volcker story in India is that of former RBI governor C. Rangarajan, who wrestled inflation into the ground. His work helped lay the foundation for India's great growth episode from 2002 to 2009. His efforts created the macroeconomic stability in which the private sector gained confidence, invested, and invested for the long term. However, a full transformation of RBI and its goals was not undertaken at that stage. After Rangarajan and Tarapore, RBI focussed on the exchange rate. This gave us the next inflation crisis.

Our task in India today is to recreate that environment of private sector confidence. This involves many things. Alongside the political challenges of the Food Security Bill and the Lokpal Bill, there is the economic policy project of reforming RBI so as to remove the distractions of numerous functions, and refocus RBI on the task of achieving macroeconomic stability: through being held accountable for achieving year-on-year CPI inflation of 4 to 5 per cent.

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