The Hindu Business Line : Monetary policy intervention

The current inflation spurt is not the result of consumer demand pressures as much as a flawed currency policy and high interest rates, says ASHOAK UPADHYAY.

High interest rates are blamed for forcing prices upwards, including of steel and cement, commodities in great demand in a booming economy.

When a select group of CEOs of member-companies of the CII met the Finance Minister, Mr P. Chidambaram, recently, the least they expected was a shoulder to cry on; interest rates were pushing up costs, power and raw material shortages were raising input costs, and both were reflected in high prices that were scaring consumers, that in turn was leading to scaling back of output and so the downturn in a period of inflation.

What they left the meeting it was with a rebuff and some kind words. There was no question of the government telling the RBI what to do, interest rate management was the central bank’s job and in any case, just for their information, credit growth was quite healthy; so was consumer demand.

After all, Mr Chidambaram reminded them, the government was pumping money through its various schemes that were bound to raise incomes. Slowdown? What slowdown, he seemed to be asking.

The Finance Minister’s attitude bears testimony to the times his government is passing through. Elections are round the corner and he was talking to another, invisible constituency. His words were meant to convey a sense of commitment to good governance.

The job of controlling inflation was the central bank’s and it was doing a good job. The government was pitching in with its responsibility of public spending, so that was that.

The argument seemed impeccable but it is grandstanding. The idea that credit growth had grown in this current year despite high interest rates was first highlighted by Mr Leeladhar, deputy governor of the RBI, a few weeks ago. With an average of 24 per cent, non-food lending this year would seem to have surpassed last year’s.

Mr Leeladhar’s observation seemed to answer the Finance Minister’s repeated requests to bank chiefs not to slow credit down even as the RBI continued to make it dearer with every increase in the repo rate and CRR. But as one commentator pointed out, that growth figure does not account for inflation.

If you adjust that growth against the WPI of over 12 per cent, real credit growth has slipped from the previous year when inflation was around 4 per cent.

Firms are borrowing more to pay for the rising costs; banks are lending more to enable firms run in the same spot. That logic applies equally to the extra spending that the government will incur, say for the Sixth Pay Commission arrears and incremental salaries for government employees.

The farm debt waiver will wipe the slate clean maybe and that’s about it. In the medium term, the impact of both on inflation through a spurt in the incremental propensity to consume will be marginal to say the least, given the scale of the inflationary leap over the last two quarters.

Whose task is it?

The idea that the battle against the price rise was really the job of the RBI seemed odd too. Historically, governments and especially finance ministers have never let go the perception they had a role to play in inflation control.

When the WPI was around 7 per cent, Mr Chidambaram warned of stern fiscal steps to control inflation even if they involved some sacrifice of revenues “badly needed for social sector spending”.

Speaking to the Press Trust of India in Washington where the finance minister of the world’s second fastest growing economy was attending the meeting of the World Bank and the IMF, Mr Chidambaram gave the impression of waging a strategic battle against inflation.

Since then, the government appears to have lost the will to do anything else than hope that good fortune again swings our way and oil prices soften enough to have a benign effect on domestic inflation rate at least by March. Till then, New Delhi will leave it to Mint Street.

When theory fails

So frequently has the RBI reacted to spurts in inflation since last June that the public has begun to expect a similar reaction almost with an air of resignation; markets take the repo and CRR hikes in their stride.

The relationship between monetary policy and inflation in India is cast in stone at a time when that textbook principle, defining the effectiveness of central bank intervention against inflationary pressures, is in need of questioning.

That need arises from the nature of inflation in India, indeed in most parts of the developing world that has been experiencing high growth. Inflation in most Asian economies has not been stoked by demand pressures, as the RBI wants us to believe is the case with India, but by supply constraints, especially in food and energy.

That much seems self-evident, given the reams of analyses on commodity prices, and the dramatic rise in oil prices, especially since 2002.

High-growth Asian economies dependant on energy-intensive industrialisation, such as India, have had to pay that much more for the expensive oil and food from Europe and the US in exchange for their cheap exports. India that was almost self-sufficient in food till a few years ago is now in the unenviable position of having to import wheat and rice, and inflation.

The global surge in prices does not hurt western economies as much as Asian ones because western economies are less-energy intensive and the surge in oil prices is offset by cheap manufactured imports from east Asia and China. But India has an additional problem in its stagnant agriculture that adds to the shortages and price increases.

Inflation, in the first instance, therefore, is not the result of demand pressures, as the RBI insists but the consequence of cumulative policy failures in reviving a moribund rural sector; global inflation simply compounds the problem but did not create it.

Unlike the western consumer, the Indian consumer spends a lot more on food and various forms of energy, a dependence that contributes to the increasing spiral of prices. That is why the RBI’s monetary tightening will have little impact on domestic prices.

On the other hand, the ratcheting of interest rates will contribute to the spiral as is evident from the last two quarters, a spiral that has gripped industrial output in its vortex.

When the CEOs met the Finance Minister, the burden of their song was that high interest rates were adding to their costs and forcing prices upwards. That is the case with steel, cement, two commodities in great demand in a booming economy. Short supplies and high costs feed off each other and high interest rates are a potent ingredient.

Currency and monetary policy at odds

To be sure, the RBI locates inflation also in excess liquidity as evidence of demand pressures and reflected in a stubborn M3 that refuses to be corralled within the tolerable range of 14-17 per cent. But that excess liquidity is not the result of the traditionally understood “demand pressures” so much as the consequences of the RBI’s sterilisation of dollar inflows.

The huge build-up in foreign exchange reserves over the last three years has led the RBI to a currency policy that is actually contributing to inflation despite its best intentions. Mopping up dollars to keep a favourable exchange rate for exports means more rupees in the economy which forces the central bank to engage in another mop-up, this time of rupees.

In the twelve months since last June, the CRR and repo rates have been increased manifold with one single purpose in mind, but legitimised in the RBI’s terminology as an attack on “aggregate demand pressures.” The central bank is simply mopping up the excess of its own currency policy and an interest rate that encourages arbitrage opportunities.

In a perverse sort of way, the apex bank’s monetary and currency policies mesh into each other but with deleterious results on the economy. A cheap dollar means the nation pays more for food and oil and, as is increasingly evident, for everything else too.

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