Inflation may have the last laugh

Two-thirds of the decision-making process is based on analysis and information and one-third is always a leap in the dark .

– Napoleon

The Governor of the Bank of England once said that while the market may follow the lead provided by the central bank, there could be occasions when it is the other way round.

The latest policy announcement of the Reserve Bank of India (RBI) bears out this statement. The market had expected a tightening of policy. The banking system had anticipated 25 basis-point increases in repo and reverse repo rates. Many banks have already raised their deposit and lending rates due to the difficult liquidity situation.

FISCAL ISSUES

The reviews of macroeconomic and monetary developments and policy are, as usual, comprehensive and analytical. One detects an undertone of helplessness. The RBI makes a candid admission that pressures emanating from crude oil and other commodity prices, and demand-supply imbalances in some food items, would be non-responsive to monetary policy actions. Fiscal consolidation has been emphasised.

There is an oblique reference to demand-side pressures arising out of the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS). For a long time, the official explanation for inflation was that it was due to bottlenecks on the supply side. Then there was recognition of the damage done on the demand side, when Ministers conceded the effects of the rise in incomes. There was, however, no reference to the lack of any commensurate increase in output, particularly in the agricultural or rural sector.

It is well on record that MGNREGS acts on the demand side, with insignificant addition to the productive capacity of the economy due to leakages of various kinds. Now, the latest recognition is that the current inflation is due to both demand and supply factors! Mr. P Chidambaram admitted recently in a speech that there was no complete understanding of the causes of the current inflation. Are policy actions leaps in the dark?

AMBITIOUS EXPECTATIONS

The RBI spells out the following anticipated outcomes and approaches:

Contain the spill-over effect from rise in food and fuel prices to generalised inflation;

Rein in rising inflationary expectations, which may be aggravated by the structural and transitory nature of food price increases;

Be moderate enough as not to disrupt growth; and

Continue to provide comfort to banks in their liquidity management operations.

A spill-over to generalised inflation cannot be prevented when organised labour gets compensatory allowances that will be part of the cost of the goods and services they produce. Even in the case of the unorganised labour, this may happen with an increase in bargaining power. The policy statement shows awareness of this factor.

It is interesting to read about shortages of labour for agricultural operations and increase in rural wages due to the MGNREGS. Farmers of Punjab and Haryana are affected by the reduction in seasonal migration of agricultural labour from Eastern India due to the availability of local jobs for them under the Scheme. Why should a labourer go from Bihar to Punjab, maintain two establishments and earn, say, Rs 150-200 per day, when he can get Rs 100 for a job not done in his village or near it?

The spill-over from fuel to general prices depends upon the government's action in relation to pass-through— which is not in the control of the central bank — and the importance of fuel in the input-output tables of the economy. Ninety per cent of petroleum products are in the nature of intermediates and their price increases will have secondary effects on the general price level.

The second outcome may also be difficult to realise when the central bank raises its own inflationary expectation from 5.5 per cent to 7 per cent. Is it necessary for the Bank to make such a projection? On the third and the fourth outcomes, growth may not be affected as credit flow is not likely to be constrained because of the hike in repo rate. Banks have already factored in the higher costs of deposit mobilisation and raised lending rates. There is no let-up in credit flows.

The RBI needs to reflect on the fourth outcome or objective. The shortage of liquidity is indicative of the desirable effect of monetary policy, but the Bank feels that it should not exceed its comfort zone of plus or minus 1 per cent of net demand and time liabilities of the banking system. It should ask itself whether what it has been injecting into the system through repos on a large scale is warranted.

The lender of the last resort function was basically conceived in central banking to ward off insolvency when it happens, say, due to a run on a bank. On other occasions the Bank cannot say: “Ask and it will be given to you; seek and you will find; knock and the door will be opened to you.”(Matthew 7:6-8)

How can the Bank retain the projection of credit growth at 20.0 per cent against the current trend of 24.4 per cent if it is so liberal in repos that have practically become short-term loans due to the continuous borrowing of some banks over several weeks?

It can think of asking persistent borrowers some questions on the need for repos, after it makes the funds available, in order to put them on alert.

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