A leap in the dark?

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

The Annual Report of the Reserve Bank of India is an authoritative document looked forward to with eagerness not only by observers in India, but in international institutions also. The latest Report brings the story up to the middle of August going beyond its accounting year (July-June). It maintains the high standards that have evolved over time.

One may not agree with its interpretations or forecasts. But the document cannot be faulted for factual accuracy or analytical rigour. Although this year's edition has shrunk in size, it does not detract in any way from its utility for the readers.

The uncertainties of domestic and international factors that impinge on policy making have multiplied owing to the increasing integration of economies and the instantaneous transmission of information. In this situation, the size of the economy does not matter much. The debt crises of small countries such as Greece have as much impact on the world economy as the downgrading of the rating of the US.

Under such circumstances policy-making, based on recent trends, is at best a measured and reasoned response to what has happened. Also, while one can estimate an equation and come out with prognostications, it is difficult to capture the feedback effect. Hence it is going to be groping in the dark when one tries to forecast for being pro-active. The RBI's policies need to be understood keeping this in mind.

Inertial or structural?

In para 1.48 the Report says: “Tackling food inflation also needs a strategy to break the inertial element arising from rising real wages leading to increases in the Minimum Support Price (MSP), which in turn leads to higher food inflation that feeds back to higher wages with an element of indexation……….Rural wage programmes need to be linked with productivity.”

What is referred to as ‘inertial' is really structural. We have inertial inflation when people reconcile themselves to a certain rate of price increase through adaptive changes in consumption pattern, as brought out in many anecdotal reports in newspapers. Inflation rate is then dynamically in equilibrium!

Linking wages to productivity in schemes like the MGNREGP is more easily said than done. There are enough accounts of the misuse of the scheme by both the implementing agencies and the participating labourers.

There is growth in rural employment and incomes without any corresponding increase in output unlike in the West where the discussion is about jobless recovery.

Infrastructure challenge

The RBI should be worried about the prospect of a trillion dollar expenditure on building the infrastructure in the Twelfth Plan. We do not know how much of the resources would be generated in the country and outside and how much would get spent within. In addition to infrastructure spending, there will be other expenditures on various sectors, both of a capital and current nature. The money supply (M3), at the end of March 2011, was Rs 65 lakh crore . The figure may grow up to a mind-boggling level by the end of the next Five-Year Plan.

Since infrastructure projects have a long gestation period with resultant lags in the flow of benefits to the economy, the central bank is going to face a major challenge in sticking to its agenda of controlling inflation. It will do well in starting to plan for its policy for the Twelfth Plan period, besides the one for the next year.

Threshold inflation

It is in this context that one is dismayed by the statement that in India the threshold inflation rate is 4-6 per cent, beyond which growth will be affected (page 33). There is no reference to the supporting research. Whatever study justifies the drawing of the Lakshman Rekha should be placed on the Web site of the RBI for examination by those who have knowledge of the esoteric subject of econometrics.

What is interesting is that the RBI has subtly changed its rationale for accommodating a 4-per-cent inflation rate in its monetary policy.

Demand for currency

There is a good discussion of the determinants of demand for currency and velocity (pp. 38-39).The standard error of the regression equation as a whole indicates its predictive power. In addition to the regression coefficients, their standard errors and R-squared value, it is also available in the software econometric packages and hence can be given in the future.

One important feature in India is the increasing demand for currency during election time. A dummy variable for the years concerned may perhaps throw some light on the matter.

Analysis should also take cognisance of the fact that although velocity and money multiplier are two different concepts, they can work together to counteract any monetary or fiscal policy.

This is what has happened in the US in the aftermath of the fiscal and monetary stimuli provided to the system. The extent of leveraging of the original increment in money supply through the multiplier influences velocity.

I am intrigued by the continued absence of any reference to offshore banking units in RBI reports.

The researcher is helpless as there is no other source of information for this subject.

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