A flawed understanding of inflation

In its latest review of monetary policy, the Reserve Bank (RBI) has chosen to maintain its policy framework without making any change. This is in the context of domestic and external conditions that do not warrant any change, according to its judgement. External conditions are mixed, some favourable, others not.

Headline consumer price index (CPI) inflation rose for the second successive month in June 2015 to a nine-month high on the back of a broad-based increase in upside pressures, belying consensus expectations.

Near-term inflation expectations of households returned to double digits after two quarters, although those of professional forecasters remained anchored.

Rural wage growth was moderate but there are indications of incipient pressures from corporate staff costs.

Taking into account all this, and given that policy action was front-loaded in June, the RBI feels it is prudent to keep the policy rate unchanged at the current juncture while maintaining the accommodative stance of monetary policy.

Short-term real risk free rates are nevertheless supportive of borrowing by interest rate sensitive consumer segments such as housing and automobiles. Significant uncertainty will be resolved in the coming months, including the likely persistence of recent inflationary pressures, the full monsoon outturn, as well as possible Federal Reserve actions. As the RBI awaits greater transmission of its front-loaded past actions, it will be alert to developments that open up the opportunities for more accommodation.

Those who advocate a reduction in interest rates should ask themselves whether the cost of health care or the prices of vegetables and fruits will come down as a consequence.

Today’s problem for the common man is the high price level of all goods and services that make it necessary for him to cut down the quantity he buys.

What we really need is some deflation, not disinflation. ‘Deflation’ is a dirty word in the West for different reasons. It is not so in the Indian context. An absolute fall in price level can contribute to a significant growth in the demand and the consequent production of goods and services. There were considerable references to Monetary Policy Council (MPC) in the governor’s meeting with the press. It would appear that Government will make the announcement when it feels comfortable.

It also seems that the governor will retain his veto power on the recommendation of the MPC. In fact, the independence of the governor is already evident from the fact that despite a suggestion from the Finance Ministry for a reduction in the policy rate the RBI stuck to its current stance.

The constitution of the MPC and the role of RBI Governor vis-à-vis the Council call for an amendment of the Reserve Bank of India Act 1934. There are many important ideas flowing from the Report of the Financial Sector Legislative Reforms Commission on which final decisions remain to be made.

Is it not time for the government to appoint a Commission to prepare a new law to replace the RBI Act 1934?

This Act went through several amendments and modifications over the years. But it was all piecemeal legislation to meet particular needs. No comprehensive look was ever taken on the working of the central bank and the rationale to replace the old Act. A working group should be set up to look into this aspect.

Many developing countries such as the Philippines and developed nations like New Zealand have enacted brand-new laws on their central banks incorporating new features that are in tune with the modern ideas of central banking.

A visit by this writer to the central bank in The Philippines in the past revealed how the new law that ensured autonomy to the institution worked satisfactorily. The Philippines was one of the few countries not affected much by the East Asian crisis.

In the context of India even the objectives enshrined in the Preamble to the RBI Act need to be given a second look. “Monetary Stability” is the mandate given to the RBI.

It was drafted at a time when the country was under alien rule and growth was not the concern of the government. Till the middle of the 1980s monetary stability was interpreted to mean the stability of purchasing power or price stability.

However, with the acceptance of the Chakravarty Committee Report on the Working of the Monetary System in India there was a subtle shift in interpreting monetary stability to mean the stability of the inflation rate.

The Commission sanctified an inflation rate of 4 per cent in the formula it gave for estimating the desirable money supply.

That rate became 5 per cent later and currently 6 per cent is the New Normal! The new group I have suggested for preparing a revised RBI Act may as well take the form of a second commission on the working of the monetary system.

It may consider the question of growth vis-à-vis inflation since it is now official that there is an inflation target for the RBI. Incidentally, the Chakravarty Commission did not consider the cooperative sector probably because it was not specifically mentioned in the terms of reference.

In fact I once pointed out the importance of the cooperative sector in the system to a member of the Commission and asked him to take it up with the others. Perhaps he did not follow up the suggestion.

The writer is a Mumbai-based economic consultant

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