The Hindu Business Line : Stability of prices or inflation?

Though the preamble to the RBI Act, 1934 mentions "monetary stability" as the objective of the central bank, it was quietly changed to mean a stability in the rate of inflation, variously mentioned as 5, 6 or 7 per cent, depending on the latest trend in prices. There is a qualitative difference in policy-making between the two, says A. Seshan.

The RBI headquarters in Mumbai... It is time the apex bank started reducing the size of additional liquidity on expectations of inflation.

THE Reserve Bank of India will soon unveil its mid-term review of the economy and policies giving an analytical insight into recent developments and pointing to the road ahead. There is no doubt that it is bumpy and full of potholes. It is not the one less travelled by, to use a Frostian expression.

The earlier review predicted a growth rate in the Gross Domestic Product of 6.5-7 per cent for this year. Keeping in view the expected fall in kharif foodgrains output and the good news on the manufacturing and export fronts, one may expect the unsatisfactory performance of agriculture to be made good partly by the industrial sector.

The services sector — the most important constituent of GDP — will continue to make strides, if newspaper reports are to be believed, despite the restrictive measures taken by some developed countries against the outsourcing of business to India. The central bank is likely to predict a growth rate of 6-6.5 per cent, subject to a good rabi season and the continued outstanding performance of the export sector. The bias may be on the higher side. The term "prediction", a la astrological prediction, is more appropriate than "forecast", given the guesses and imponderables which make it difficult to do a macro-modelling exercise for the economy implied in the latter. Econometricians give it a dignified name and call it a "conditional forecast".

The point-to-point annual rate of inflation was 7.2 per cent, as on October 2. The central bank had earlier predicted it at 5 per cent for the year. It is not likely to be, going by current trends. So the expectation may be an inflation rate of 6-6.5 per cent with a bias on the lower side. The irony is that the prices of luxuries, such as DVD players, phone calls and computers, are declining while those of necessities, such as foodgrains, vegetables and fruits, are rising — season or no season.

A couple of years ago bananas could be bought at Rs 10 for a dozen in Mumbai. Today, they cost Rs 20. There is also an imperceptible change in market practices. This writer went to the Matunga vegetable market in Mumbai to buy a few tulsi leaves. Purchase for the value of a rupee would have sufficed. But the vendor declared that the minimum was Rs 5. Later he observed the same minimum for buying "masala" — a mix of curry leaves, coriander leaves, ginger and green chillies. This mix was traditionally provided free in the past as a sort of baker's dozen (kosuru in Tamil), whenever one bought vegetables for a good amount. No index of prices can capture these restrictive trade practices.

Central banks in the US, the Euro area, the UK and Australia get perturbed if the inflation rate breaches their tolerable rate of 2-3 per cent and initiate action to pre-empt a steeper rise a year from now. This is because monetary policy takes time to produce an impact. On the other hand, a government spokesman said recently that people will not tolerate anything more than a 7 per cent inflation rate. Till sometime ago the "acceptable rate of inflation" to Government — not to the public — was 5 per cent. It may become 9.9 per cent in course of time because it is below double-digit inflation.

This writer remembers how, around 1983, he, as Director of the Econometric Division in the RBI, was asked to undertake a modelling exercise for incorporating inflation in the next Plan document. Planning for inflation is a cruel joke played on the poor people of the country.

The preamble to the Reserve Bank of India Act, 1934 clearly mentions "monetary stability" as the objective of the central bank. One would have thought that this meant price stability or stability in the purchasing power of money. In fact, that was how it was interpreted till the early 1980s. Then, perhaps due to the populist policies of government calling for heavy doses of deficit financing, it was realised that the old interpretation would not be feasible. It was quietly changed to mean a stability in the rate of inflation, variously mentioned as 5, 6 or 7 per cent, depending on the latest trend in prices.

The Chakravarty Committee Report on the Working of the Monetary System (1985) mentioned 4 per cent as the "acceptable rise in prices" in an illustration for monetary targeting (para 9.88). There was no debate in public or Parliament on a matter affecting millions of people. It was so subtle that even knowledgeable persons overlooked it. There is nothing wrong if the objective is changed on practical grounds. But it calls for an amendment to the Preamble to replace the expression "monetary stability" with "stability in the rate of inflation" so that the central bank need not violate the law.

There is a qualitative difference in policy-making between the two.

If monetary stability is the objective then policy will be devised accordingly. It will be an altogether different matter if it is not achieved due to reasons beyond the control of the central bank for which it cannot be faulted. But if the central bank itself aims to stabilise, not prices, but the inflation rate, then also it will formulate policies accordingly. And that is what is happening. In estimating the additional demand for money in a year the procedure in the last two decades has been to multiply the expected growth rate in real GDP by the income elasticity of demand for money. The latter is the percentage increase in demand for money for a 1 per cent rise in real GDP.

Then, instead of providing for only that much money, it adds, on the supply side, another 5 per cent by way of baker's dozen to take care of anticipated inflation. It would tantamount to planning for a 5 per cent-inflation! This writer has always wondered as to what would happen if the extra money is not supplied. There has been some debate in the country on legislating a ceiling on inflation rate under which the central bank would be mandated to ensure that it is not exceeded. The fact is that there is already such a target, as expressed by the authorities and incorporated in estimating the supply of money. Only it is not designated so in law. It is time the RBI started reducing the size of additional liquidity for anticipated inflation. The financial system is now drunk on excess liquidity though it is coming down. A steep and sudden reduction in monetary growth will result in a tremendous shock and severe withdrawal symptoms. The system should be weaned gradually in a phased manner from the excess over the medium term.

The economy is showing signs of revival. The credit flow and the incremental credit-deposit ratio have been rising steeply in the recent period. So the RBI cannot think of raising the cash reserve ratio implying a cut in the availability of credit. It will also run counter to its commitment, to be reiterated in the next policy statement, to provide funds for all genuine activities of production and investment. The other aspect is the cost of credit. The RBI's hands have been somewhat tied by the desire of the Prime Minister and the Finance Minister to maintain the existing low-interest-rate regime. It is indeed strange that they express such wishes in public and, in the same breath, declare that it is for the RBI to decide. It may think of raising the Bank Rate and the related ones by 50 basis points. The public will then see the central bank as doing something to halt inflation instead of being a mere observer on the sidelines.

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy of the Reserve Bank of India.)

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