The Hindu Business Line : Return of inflation: Challenge to monetary policy

SPEAKING on the occasion of the Budget on July 8, 2004, the Finance Minister, Mr P. Chidambaram, referring to the price situation, said: "Although there are short-term pressures on prices, the outlook for the year is benign and the Government is fully alert".

This is in spite of warnings that emanated from sources, like IMF's World Economic Outlook. More to the point is the RBI's stance on prices indicated in its Monetary Policy Statement of May 2004: "In regard to prices, there is an overhang of problems on account of oil prices and large domestic liquidity, partly reflecting global liquidity.

"However, in view of India's proven resilience to shocks, reasonable levels of food stocks coupled with prospects for a good monsoon, and the comfortable foreign exchange reserves, the price situation during 2004-05 is unlikely to cause concern to macro stability; but both on welfare considerations and impact on inflationary expectations, a very close watch is needed on the implications of global and other developments for India".

Perhaps, the RBI can claim that it had referred to the overhang of problems on account of oil prices. But, one expects a greater clarity on such sensitive issues and a sharper focus on research on price trends from the country's central bank.

Leaving aside this post mortem on the credibility of price forecasts by policy-makers, we have now to see what they will do to handle the re-emergence of inflationary trends.

The latest inflation figures show that the wholesale price index (WPI) has shown a year-on-year rise on a point-to-point basis of 7.6 per cent. As of August 14, 2004, primary articles with a weight of 22 per cent in the WPI accounted for an increase of 6.3 per cent.

Among these, fruits and vegetables accounted for an increase of 3.8 per cent. So much for the furore about onions and baingans. While they are costlier, they do not account for the whole thrust upward. Fuel, light and lubricants (all discordants of OPEC-led crude prices) accounted for just 3.8 per cent with a weight of 14.23 per cent. There is greater danger lurking here, given the limits to fiscal largesse in terms of writing down customs and excise duties!

Edible oils with a weight of 2.76 per cent accounted for a price increase of just 0.6 per cent. This cannot hurt too much. More impressive among the price movers was steel with a weight of 3.64 per cent in the WPI and a rise of 42.3 per cent.

Inflation of over 7.6 per cent is, indeed, new, given India's recent history of benign experience. Crude oil price increases as well as steel reflect the rise in global demand. Government's efforts in the form of suasion of industry majors, like Tatas, have had some effect.

But, there is a limit to which Corporate India can do to address effect such Government-induced reductions. SAIL is also losing its potential profits for every such decrease enforced by Government suasion.

"Inflation", said Milton Friedman, "is always and everywhere a monetary phenomenon." But, recent global and Indian experience would contradict the Nobel Prize winning economist. The rise in wholesale price index in recent months has essentially been the result of rising global demand and shortage in supplies. There has been, of course, an accommodating increase in global liquidity, but the cause of inflation is not monetary expansion.

What the oil-producing countries decide and what Chinese construction programmes demand is what has primarily impacted the world price situation. So much so, China, which faced a threat of deflation some months back, is now facing an inflation of 5.1 per cent — a rate it has not seen for years. The US itself is facing an inflation rate of 5.3 per cent, up from 2.1 per cent. Global inflation is very much back in the reckoning.

We have in Dr Manmohan Singh a veteran of many successful battles in economic reform. One of his well-known triumphs is his successful fight for controlling inflation, which had reached the high figure of 25 per cent in 1973-74 and 1974-75. Dr A. Vasudevan had detailed his various initiatives in an interesting article in Business Line of August 19, 2004.

I am sure Dr Manmohan Singh will not fail to communicate some of the lessons of that encounter with inflation to both Mr P. Chidambaram and the Governor, RBI.

Dr Manmohan Singh's actions in the seventies were, however, centred on strong retrenchment of bank credit, escalation of interest rate, freezing of portion of dearness allowance through compulsory deposit schemes and cut back of public expenditure - a dramatic set of measures.

The current situation facing the policy-makers at North Block and Mint Road is different. Whereas in 1974-75, Dr Manmohan Singh had a single-minded objective of slaying inflation, today he is at the head of a Coalition Government, which has got a multiplicity of goals. He cannot look too kindly on a measure, such as sharp escalation of lending rates, cut in bank credit, freezing of DA and so on. What can Government and RBI do in this context?

One possible policy option — difficult though it is — is to nudge interest rates upwards. Already, there is a global trend towards such rise in interest rates. Further, there is need and justification for preserving a positive real interest rate — the difference between inflation and monetary rate.

The RBI has to consider carefully this option of an increase in interest rates — not confined to repo rates. There is no point in avoiding the rise in Government coupon rates, although it might hurt the fiscal deficit of both the Centre and the States. Inflation cannot be fought by ignoring the real cost of money, which is what real interest rates are.

The RBI has to move the bank rate upwards. If it means an adverse impact for bank bottom-lines, so be it. The bankers' and corporates' honeymoon with low interest rates and high treasury profits is over. The time has come to face reality. Will the RBI also raise the CRR? This is doubtful, considering the political mandate to keep the flow of credit at a higher level, particularly to the farm sector. There is also the need to keep investment going at a high level to meet the objectives of high GDP growth.

The central banker's job is truly rendered difficult as he has to control inflation and induce investment at the same time. One or the other objective has to give. Inflation will ultimately have a definite adverse effect on investment projects' profitability. To thrust more funds into new investment in an inflationary situation without caring for returns is not true banking.

Should RBI encourage appreciation of the rupee to reduce further imported inflation? Here again, there is a problem of competing objectives. An appreciating rupee is a disincentive to exports of both goods and services and by the same token an incentive to imports.

The RBI has, however, to take into account the fact that the present policy of keeping the rupee relatively steady at low levels means a large strain on monetary management. Hopefully, the central bank will address these conflicting demands in its forthcoming monetary policy statement due in October 2004.

So far as Corporate India is concerned, the return of inflation means a mixed blessing. On the one hand, it may improve its bottom-line. On the other, it has to be prepared for a stiff competition in export market. It has also the added danger of disruption in labour-management relations.

All told, the inflationary phenomenon is new to reforming India. It is more than a decade since we confronted high inflation. The practitioners of the art of monetary policy have to come to terms with how to handle the tools of this policy in keeping with the demands of the political masters. There are no easy answers. But, the time for complacency is over.

I cannot do better in this context than quote Dr Manmohan Singh himself from a speech of his delivered on December 18, 1982 at Mumbai: "The objectives of monetary and credit policies have to be consistent with several objectives of national economic management".

At that time, he called for an enquiry into the various issues that this dilemma involves. "There are a large number of investments having a bearing both on the management of aggregate demand and the allocation of resources among different sectors. How does monetary and credit policy fit into all this? How much weight ought to be placed on monetary and credit policies to achieve our national objectives?

Can monetary planning be harmonised and coordinated with national planning? How effective are various instruments of monetary control in achieving these objectives? How does the increasing openness of our economy impinge on the effectiveness of monetary and credit policies"

With a view to addressing these issues, Dr Singh arranged for the setting up of the Sukhomoy Chakravarthy Committee, which gave a comprehensive report in 1985.

The time has come for post-reforms India to revisit the issues that Dr Manmohan Singh has raised so perspicaciously. Our renewed encounter with inflation makes a reinvestigation of these issues imperative.

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