The Hindu Business Line : The inflation debate

There is much to be said in favour of the argument that the RBI should look at inflation control from the point of view of what it does to economic activity in general and not focus only on wholesale price index.

The solution to inflation in India lies in the efficient and increased production of food grains in the country itself.

S. Venkitaramanan

The news is that the index of industrial production (IIP) has registered a decline to 5.4 per cent for the latest period compared to 8.4 per cent for the corresponding period of last year. The decline is inevitable considering that the monetary authorities have resorted to monetary tightening of a strong nature, both in terms of liquidity and rates. This can be expected if inflationary pressures continue, as interpreted by the RBI in terms of the wholesale price index.

The debate on inflation in the country has been marked by an important technical argument as to whether the RBI has been right in focusing its policy action on the wholesale price inflation figure instead of on consumer price index (CPI) inflation. Around the world, most other countries take into account consumer price inflation rather than the wholesale price inflation. Dr Surjit Bhalla, the renowned economist, has argued in various articles that this confusion leads to a more severe tightening than the reality of the situation demands and that our current inflation, as measured by the consumer price index, is not worse than many countries. After all, it is the consumer price inflation that consumers are bothered about. The dearness allowance of Government servants is, in fact, linked to consumer price index.

Targeting inflation

India’s inflation, measured by the consumer price index, has been of the order of 7.8 per cent as against the wholesale price inflation of 11.9 per cent. As against this, China’s CPI inflation has been of the order of 7.1 per cent. If the focus of RBI is placed on the consumer price index, the tightening needed may be less. Let us also consider that the average CPI inflation for the developing countries of the world as a whole is 7.2 per cent compared to the wholesale price inflation of 12 per cent — a difference of nearly 5 per cent. Obviously, there must be some reason why the RBI is sticking to targeting the wholesale price inflation instead of the consumer price inflation. But, it cannot ignore the fact that even developed countries such as the US, the UK and the Euro region, are focusing on consumer price index rather than the wholesale price index.

The US, for instance, has a consumer price index-based inflation of 5 per cent while its wholesale price inflation is 9.2 per cent. Similarly, the UK has an inflation of 3.8 per cent on consumer price as against 10 per cent on wholesale price. Similar is the story with other countries in Europe. The developed countries’ inflation on consumer price basis has been 4per cent as against 7.6 per cent on wholesale price index — the same order of difference as in India.

Central bank’s reaction

The question arises whether concentrating on the higher of the two variables — namely wholesale price index — satisfies the subconscious urge of the RBI to tighten its interest rate policy and other monetary measures more severely than justified by reality. The central bank’s reactions to inflation differ from country to country. In the US, the Federal Reserve system is mandated to keep in mind employment creation as well as price stability.

The central bank has to preserve its sense of balance in its approach to inflation control. In the Euro area, however, the European Central Bank has been governed by the traditions of the Bundesbank of Germany, which had followed the objective of price stability above all else. This emphasis was partly based on the bitter national memories of the experience of the post-World War-I years when Germany experienced a hyper inflation. Mr Trichet, President of the European Central Bank, following this Bundesbank style mandate, thought it fit to be hawkish in his approach and tightened interest rates far beyond what the US has done under similar circumstances.

Lender of the last resort

Under Mr Bernanke and Mr Greenspan, the US Fed has, of course, followed a more liberal policy. This is especially so in its recent handling of the liquidity crisis brought on by the collapse of the various financial institutions in the country. It has acted as a lender of the last resort to institutions other than banks even at a risk of accepting securities, which are less than top grade. Mr Bernanke has thought it fit to expand the role of the central bank beyond its original charter to maintain employment in the economy, of course within the broad confines of price stability, determined in terms of consumer price variations.

The action of the RBI in tightening monetary policies in the recent statement to bring down inflation based on the wholesale price index has led to the real rate of interest rising sharply, higher than it would have been otherwise. Our real rate of interest on a three months’ basis is 1.3 per cent as against China’s (-) 2.7 per cent. Among the developing countries, only Mexico has a higher real interest rate at 2.8 per cent compared to India. The point is that creating this tight real rate of interest environment makes it difficult for entrepreneurs to start new enterprises. Equally, activities in the consumer durable markets become sluggish because borrowers have to pay higher EMIs. The same is true for housing loans also.

Inflation management

The net effect of the tighter-than-needed inflation management is realised in a lower growth of the economy, particularly of manufacture and services. All this has come at a time when the country is poised on the brink of initiatives by the Government to create new job opportunities through expanded environment for manufacturing services and agriculture. The pursuit of monetary tightening has perhaps gone a little too far considering the pain it inflicts on the economy and the little gain it has to show in managing inflation.

There is also much to be said in favour of the arguments of Dr Bhalla that the practitioners of too tight a money policy have comparatively little to show in respect of control of WPI inflation. The Euro area, for instance, has had a WPI inflation of nearly 6.7-10 per cent notwithstanding a tight monetary policy. The US, on the contrary, has only a WPI inflation of 9.2 per cent in spite of its relatively benign interest rate. There is, therefore, much to be said in favour of the argument that the RBI should look at inflation control from the point of view of what it does to economic activity in general — CPI in particular — and not focus only on WPI. A more nuanced attitude towards monetary tightening is especially necessary when most of the inflation in India is based on imported inflation arising from the increase of crude oil prices and the prices of food grains in certain countries.

Increasing productivity

The objective of the RBI’s monetary policy on the other hand should be on how to increase productivity and production in the country rather than on restricting the rise of wholesale price index. Further, if the monetary policy in pursuit of too tight a growth of inflation leads to reduction of credit availability at reasonable rates to the producers and builders of infrastructure, it will be self-destructive.

Ultimately, the solution to inflation in India lies in the increased supply of locally-produced goods and services — through efficient and increased production of food grains and manufactured goods in the country itself. This cannot be achieved by a single-point agenda of attention to wholesale price index inflation as practised by the RBI today. “Shift focus on consumer price index rather than WPI index and let us see the difference” is what I would say to the authorities.

(Responses to blfeedback@thehindu.co.in)

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Inflation targeting and India

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