A new normal for inflation?

In its latest review, the Reserve Bank of India has opted, by and large, to retain the existing policy with a reduction only in the statutory liquidity ratio (SLR) by 50 basis points. The economic environment has shown signs of improvement both domestically and externally, but the improvements are not adequate for any strong liberalisation measures, particularly in relation to the rate of interest.

There are three aspects of stability with which the Central bank is concerned, namely, economic, financial and price trends. The RBI is obviously cautious enough not to be misled by false dawns in an environment of risk and uncertainty.

That the RBI is responsive to suggestions, though with considerable time-lags, is brought out from time to time by the changes it makes in its analytical approach.

Thus the emphasis on stability has shifted from Wholesale Price Index (WPI) to Consumer Price Index (CPI). In fact, I think it is for the first time that there is no mention of WPI, and short-term ‘targets’, if they may be called so, are with reference to CPI — 8 per cent in January 2015 and 6 per cent a year later.

Both are above the comfort zone of the RBI at 5 per cent. Does it mean that the central bank has quietly accepted 6 per cent as the new normal for inflation?

Earlier, under the old management, there was talk about the new normal of 6.5 per cent. It was criticised and there was no subsequent official reference to the idea. One hopes the Central bank will stick to the level of 5 per cent even though it too is high for a poor country with millions struggling to make ends meet.

There is an anomaly in this. The policy is to keep the real effective exchange rate stable. Western countries and Japan have adopted a range of 2-3 per cent as the targeted inflation rate. If our rate is more than that by two to three points, would it not come in the way of maintaining the real exchange rate for the rupee?

One important point is that there is no longer any reference in the recent period to the inappropriate use of the western concept of ‘core inflation’.

I have argued that our concept should include inflation in food and fuel prices and not exclude them as, for example, in the US. A worrisome feature is that the inflation rate in rural areas, the source of agricultural supplies, is more than that in urban areas.

All India general CPI inflation dipped to 7.3 per cent in June 2014 from 8.3 per cent in May 2014, mainly driven down by a decline in inflation for food articles. Inflation rates for rural and urban areas for May 2014 were 8.9 per cent and 7.6 per cent, respectively. The corresponding provisional inflation rates for rural and urban areas for June 2014 were 7.7 per cent and 6.8 per cent, respectively.

The official explanation is that the rural population is shifting to protein-rich products due to improvement in incomes as a result of initiatives such as the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS). The higher rate of inflation in rural areas in respect of cereals, fruits and vegetables can only be explained in terms of the higher demand consequent to schemes that are in reality merely distribution of doles with no contribution to output.

Another area where the RBI has responded favourably to past suggestions is in giving up indicative targets for money supply, deposits and credit. In fact, the policy statement has given them up for the first time in recent memory. This is welcome. I have argued in the past that just saying no worthwhile productive activity will suffer due to lack of credit should be adequate to reassure the economy against any shortage of resources without mentioning indicative figures..

Indicative targets like yearly credit growth help only in competitive window dressing, with each bank trying to show that it has done better than others. (The RBI has not been able to stop the practice of window dressing despite the presence of experienced deputy governors in charge of banking operations; they had themselves indulged in it as chairmen of commercial banks.)

The only point with which I do not agree is when the RBI refers to the base effect in explaining variations in inflation rates from year to year. In all the econometric literature I have read on the subject, I come across this explanation only in India. It is a mathematical and not an economic explanation. While I can understand economists in the private sector unfamiliar with quantitative techniques giving the base effect explanation, competent RBI econometricians should not refer to it.

Contrary to expectations, the final decisions on the recommendations of the Urjit Patel Committee have not been announced, though some have been implemented in a piecemeal fashion. Hopefully, the position will be clear before the next policy review.

The writer is a Mumbai-based economic consultant

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