Get real about inflation

Reserve Bank of India (RBI) expert committee under the Deputy Governor Urjit Patel has recommended that the central bank make containment of consumer price index (CPI)-based inflation within 6 per cent the “predominant objective” of monetary policy. This has been construed by some as a hawkish position given that CPI inflation is currently at 9.9 per cent, way above the 6.2 per cent annual increase in the wholesale price index (WPI). The panel’s report has further advocated that real interest rates be positive. This would require RBI’s own benchmark ‘repo’ or short-term lending rate be set at not less than 9.9 per cent. So, will Governor Raghuram Rajan then have to raise the repo rate from the current 7.75 per cent in his next January 28 policy review, as opposed to keeping it unchanged or even reducing it in deference to India Inc’s and the Government’s wishes?

A closer reading of the Patel committee’s report suggests that such apprehensions are misplaced and its recommendations are supposed to kick in only in the future. The panel has said that the targeted CPI inflation of “4 per cent with a band of +/- 2 per cent around it” be set over a two-year time frame. So, it’s is hardly the committee’s case that the repo rate has to be brought to CPI-parity levels in Governor Rajan’s next monetary policy review. This would obviously be disastrous in a scenario where India is headed for negative average industrial growth in 2013-14 — the first time in 34 years. What the RBI panel is really looking at is to bring CPI inflation down to 8 per cent over the “next 12 months” and to 6 per cent the following year. Going by the Patel’s committee’s formula, a repo rate hike is therefore not in order at least until early 2015.

On the whole, the panel’s view that low and stable inflation is a necessary precondition for sustainable high growth cannot be faulted. Also, no one would question its choice of CPI over the WPI as nominal anchor for monetary policy formulation, since it is the former that really impacts households and influences their investment decisions. Besides, real interest rates cannot remain negative for extended periods without risking the flight of savings from bank deposits and other financial instruments into gold and real estate. We have seen such ‘de-financialisation’ of savings happening since 2009; large-scale gold imports are only a consequence of the search for an effective hedge against inflation. Tethering the RBI’s policy rates to retail inflation is a sound approach, even if the RBI is helpless when it comes to the prices of food and fuel, which have a combined 57.1 per cent weight in the CPI. But there is no case for doing so immediately in these severely growth-challenged times.

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