The Hindu Business Line : How to contain inflation

Increasing interest rates reduces the demand for money and increasing the CRR reduces the supply of money. Both have the effect of making money costlier.

Milton Friedman once wrote, "Whatever its proximate source, inflation is a disease, a dangerous and sometimes fatal disease, a disease that, if not checked in time, can destroy a society." Inflation, as everyone knows, is contained or controlled through monetary policy.

Monetary policy means the hiking or easing of interest rates, and the former is applied when inflation is on the rise and it is usually done by the central bank. Increasing the interest rate is called a tight monetary policy and decreasing it constitutes an easy or accommodative interest rate policy.

However, such monetary policy is an imprecise science. This is because while the policy has a short recognition and implementation lag (the time it takes to recognise that there is incipient inflation and act on it), the impact lag (the time it takes for monetary policy to work) is long. There is no precise time as to when the effects of monetary policy will be felt but it is generally acknowledged to be around six months. That creates a bit of an issue for the central bank since there is the possibility that the inflation could have already subsided by the time the impact of the policy is felt and it could negatively impact the economy. That is, however, a risk a central bank must be able to handle. At the risk of sounding callous, it's part of its job.

The CRR tool

In India, the RBI has another tool to contain inflation — the Cash Reserve Ratio (CRR). The RBI, by hiking the CRR recently by a total of 100 basis points over the past 2-3 months, has sucked an enormous amount of money out the system. While the monetary policy increases the cost of money and hopes, thereby, to reduce the demand for it, CRR is a bit more forceful. It just takes the money right out of the system. So in effect, increasing interest rates reduces the demand for money and increasing the CRR reduces the supply of money, but both have the effect of making money costlier.

However, one must realise that most central banks in the world only have the interest rate to work with and even for the RBI, tinkering with CRR cannot be a long-term option because increasing it imposes a kind of tax on banks because they must keep money idle that could have otherwise been earning them money.

Developing credibility

The easier option for the central bank than having to keep adjusting the interest rate is to develop credibility that it is an inflation hawk. In other words, it takes all kinds of preventive policies to nip inflation in the bud. However, one must place a huge emphasis on the word credibility. It is a gradual process. There are several ways how this credibility can be achieved. The first is that the central bank must be independent and free from all political pressures. The second could be setting an inflation target.

New Zealand, for instance, had an innovative way of increasing the credibility of its central bank, the Reserve Bank of New Zealand. After years of high inflation, the country, in 1989, passed the Reserve Bank of New Zealand Act which had a statutory objective that read: "To formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices." Also, the governor of the central bank was liable to lose his/her job if inflation rate crossed a certain range.

Inflationary expectations

The best thing about the central bank being seen as an inflation hawk is that it reduces inflationary expectations. An example of how inflationary expectations can impact inflation is unions negotiating higher wages because they expect a higher level of inflation. The company will then pass on this increased cost to the consumer and this will show up as higher prices.

Currently, Zimbabwe is a perfect example of a country in the throes of inflationary expectations. Inflation is currently running at 1,600 per cent and everyone has been demanding higher wages to keep ahead of it and this has turned into a vicious circle. Zimbabwe, however, has done the incredible, and taken the fastest way out of inflation. It has outlawed inflation!

Sunil Rongala,

Group Economist,

Murugappa Group.

(Send in your queries on economics to Whackonomics@gmail.com)

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