The Hindu Business Line : Inflation dynamics: Why fight shy of it?

It is time it was realised that inflation could be volatile, more than growth. And it is also time the current and expected inflation rates are tracked. Though the options are limited for the policy-makers, what with competing demand on public expenditure which makes rearranging spending priorities difficult, the Government and the central bank must come up with credible policy approaches at the earliest, says A. Vasudevan.

INFLATION — the rise in commodity prices at the retail level on a sustained basis — can be a political problem anywhere in the world. For countries that have experienced high inflation rates, as in Latin America, single-digit inflation rates hardly matter. However, where the trend rates of inflation are low, a rate anywhere close to the very first two-digit mark could pose a problem.

The long-term inflation rate, measured in terms of movements in wholesale prices in India is around 7 per cent. In the week ended July 24, 2004, the rise in the year-on-year wholesale price index was over 7.5 per cent without taking into account the price increases that would inevitably take place once the international oil price hikes are reckoned.

As there would be a `mark up' over the wholesale prices by retailers, consumers would pay more than what the wholesale price index reflects.

India is lucky in that it has in its Prime Minister not only an outstanding economist but also one who has passed through the inflation fire in 1973-74 and 1974-75.

Readers may recall that Dr Manmohan Singh along with Prof P. N. Dhar, at the level of the government, and Dr R. K. Hazari and Dr K. S. Krishnaswamy, at the Reserve Bank of India, were subjected to severe criticism from both economists and journalists when annual inflation during these years touched the all-time (since Independence) peak levels of 25 per cent-plus. Yet, they could successfully contain inflation.

During those years, the money supply growth was high partly because of high fiscal deficit financed by the RBI. There was also the trigger in the form of the first oil shock in 1973. The familiar analytical explanation of inflation in terms of excess demand and cost-push was clearly in evidence. Policy actions, therefore, were centred on strong retrenchment of bank credit, escalation of interest rates, freezing of payment of dearness allowances through compulsory deposit scheme and cutback of public expenditures.

But this was possible because the policy regime was centralised and highly regulated. We do not have such a regime now. Anti-inflation policies, therefore, would have to be in tune not only with market expectations but also with the chartered institutional and macroeconomic framework for the medium term.

The intriguing part of today's policy environment is the oft-stated revelation that the sharp rise in the wholesale price index in July was unexpected! This sounds odd because policy-makers are expected to monitor all the time all the macroeconomic indicators. My take here is that since commodity prices did not rise in recent years, in particular during the last four years, the policy-makers may have turned complacent.

In fact, cautions by outside observers about the need to monitor prices of critical items and to maintain price stability on a sustained basis through regular analytical and empirical studies have been politely ignored. For the policy-makers, all that mattered was to have what was perceived by them to be a tolerable inflation rate of 4-5 per cent a year.

Since this was realised in recent years, the policy focus was limited to ensuring that interest rates are consistent with the inflation rates so that there would be an incentive to invest and accelerate economic activity.

The reported immediate reactions of policy-makers to the inflation news are rather casual. Some of them are noted here:

There is no need to change the stance of interest rate policy; there is no standard measure of real interest rate;

The benchmark rate cannot be the Bank rate or repo rate but has to be the prime lending rate;

Reducing the rate of interest on short-term deposits by SBI is a reflection of excess liquidity in the money market;

The price spurt is unexpected and could be seasonal;

Price increases are temporary and would decelerate by the end of August now corrected to September; and

Price developments would be closely monitored.

Fortunately, the confusion arising from such reports was cleared at the initiative of the Prime Minister, whose meeting on August 9 with the Finance Minister triggered the need to bring together the fiscal and monetary authorities to work out arrangements to douse inflation expectations.

Since then, reports have appeared about the possible actions that the authorities could take. But the options are limited. With competing demands on public expenditure, the fiscal authorities would not be able to easily rearrange expenditure priorities. But they can reduce Customs duties and other levies.

Price controls are out of question. They could import some strategic items to improve supplies. They cannot, however, afford to give larger subsidies and higher prices for procurement operations though these could well occur for extra-economic reasons. Fiscal deficits would widen.

On their part, the monetary authorities would do interest rate smoothening, in a `measured' way to borrow the Fed's (or is it Mr Alan Greenspan's?) terminology, notwithstanding remonstrations to the contrary. The RBI is aware that this would have an adverse impact on the already weakened bank balance-sheets.

Curbing bank credit when credit needs to pick up is not a good option. Nor is there much scope for diversification of credit across sectors. They can, however, allow the exchange rate to appreciate.

But as the market has already discounted these factors, these actions may not have a perceptible effect on price expectations particularly since there are still many uncertainties about the oil price outlook and output growth.

It is time it was realised that inflation could be volatile, more than growth. And it is also time the current and expected inflation rates are tracked. Inflation variability and output variability are useful tools for policy analysis even where the objective of policy is not inflation targeting but multiple targeting.

Inflation expectations surveys have to be undertaken, as in some countries, and expectation models would need to be generated. There are not many good empirical studies on this subject in India for the period beginning with the current policy regime. Most studies have used long-time series data relating to regimes of different degrees of administered pricing and have therefore become irrelevant.

The RBI could take up this subject as the main theme in its Report on Currency and Finance for 2003-04. Or it could get studies, including the correctness of the indexes on inflation, done by outside experts.

Such studies help avoid the misunderstandings that have crept in due to the terminologies used for explaining the interest rate phenomenon and for viewing the `benchmark' rates in different ways at different points in time. They should also help understand the real interest rates.

Direct, simple messages about interest rate policy and fiscal actions would be needed. There are far too many downside risks relating to agricultural and industrial output growth during this year, FDI flows, the role of the organised labour, and public sector divestment. Is it too much for households and investors to ask for credible policy approaches from the Government and the central bank of the country at the earliest?

(The author, a former Executive Director of the Reserve Bank of India, can be accessed at asurivasudevan@hotmail.com)