All that waffle on inflation

All of us know that politicians in India — at all levels — rarely fulfil even the basic needs of the people. Politicians also know that well — to the extent that when they do something very basic, they tom-tom that in the loudest manner possible. For instance, a bus shelter or garbage bin — constructed after public opinion is galvanised to force official action — is advertised as great public service.

But, what would you say when a government body wants to fulfil its responsibility to the common man without proclaiming it from the roof-tops, but is told (by public opinion and the “intellectual consensus”) that it need not do its job?

That is what is happening in India currently.

‘ECLECTIC CAUSES’ SCHOOL Even as the nation’s central bank, the RBI, is finally coming round to the position that monetary policy has to take the prime responsibility for rolling back inflation, the “intellectual consensus” says the RBI is not the appropriate agency to bring inflation down. Monetary policy and interest rates are irrelevant in the Indian inflation environment, says this body of opinion.

Budget deficits, fuel cost increases, supply-side constraints, food and inflation in other basic commodities — these, according to proponents of the “eclectic causes” theory of inflation, are the forces driving up prices. They maintain that interest rate increases in the face of these various non-monetary phenomena and factors are futile. Deep supply-side reforms are the only solution, they say.

But what does the RBI itself say? To quote from a recent speech of its Governor: “We can spend a long time debating the sources of this inflation. But ultimately, inflation comes from demand exceeding supply, and it can be curtailed only by bringing both in balance.”

The key question here is: If you cannot increase supply of various goods and services in the short term — and in India, this could well be five or even 10 years — then does the RBI (monetary policy) still not have any role to play?

The proponents of the “eclectic causes” theory, in fact, are saying — implicitly — that when deep supply-side constraints operate in an economy, the central bank should just accommodate those constraints and shocks by money creation and maintain or even increase aggregate demand.

This is precisely what the Government had in mind when it recently said that, come what may, it would hike natural gas prices but would protect the end-consumer through subsidies.

The unanswered question, of course, is: how do you finance the subsidies? Only through central bank money creation and that is what pulls all prices up in the economy.

The proponents of the “no RBI role” theory should pause to examine what will happen if the subsidies are not financed by money creation. (Subsidies and deficits, by themselves, do not cause inflation.)

The Governor, in a recent interview to a television channel, has made it clear that India does have an inflation problem, which calls for a tough stance. Inflation is not just driven by food; services lead to high inflation and adding to it are healthcare, education and housing services. The Government has to ensure relatively low inflation, at a level where the ordinary person doesn’t have to worry about it everyday. Speculation and hoarding is not a general explanation for inflation. The Governor’s message to industry is that if inflation is not fixed now, the problem will get worse.

Inflation beyond food

The simple point in the interview is that inflation now in India is way beyond food or basic commodities alone.

A more technical validation of this point is available from the accompanying chart – showing India’s gross domestic purchases (GDP+ Imports – Exports) vis-à-vis the country’s production of goods and services (the GDP).

Gross domestic purchases are gross Indian purchases of goods and services — wherever they are produced. As can be seen, gross purchases are now well ahead of domestic production.

If gross domestic purchases convincingly and continuously exceed domestic production (which means large imports), what can be the key factor driving that? The key factor is that prices of domestically produced goods and services are well above those of foreign-produced goods and traded services.

That is, stubbornly high relative prices are driving the large Indian gross domestic purchases (imports). To put it in everyday language, inflation in India is very high, but demand too remains very high. Therefore, those who demand goods and services are resorting to large-scale overseas purchases, as they find it cheaper.

Why is Indian inflation and demand so high? It is basically because the RBI has, so far, acted as per the wishes of the “eclectic inflation causes” school and has monetised (almost completely) all supply shocks.

The chart has a critical message for the Indian rupee as well.

Persistent imbalance between gross domestic purchases and domestic production (GDP) will get corrected only through large-scale, disorderly movements in the exchange rate — if monetary policy does not do its job in time and reduce or eliminate those imbalances. The rupee’s travails of the past two years is proof of this.

(The author is a Chennai-based financial consultant.)

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