The ‘new normal' for inflation

The Reserve Bank of India (RBI) has announced a reduction in policy rates by 50 basis points. The policy statement and the document on macroeconomic developments released earlier give one the impression that the cut was done somewhat reluctantly due to pressure from the Government and the corporate sector to stop the slide in the growth of the economy.

Comfort has been drawn from the fact that core inflation has recently come down to less than 5 per cent for the first time after two years.

Core inflation refers to the balance from headline inflation after excluding food and fuel. This is a concept developed in the West, where food and fuel constitute a small proportion in the budget of the average family.

Since they are also subject to volatility in prices, central banks feel that the remaining sectors only are amenable and responsive to monetary policy actions.

Living with inflation

For India, core inflation should be redefined as that relating to food and fuel only, because they constitute a large percentage of consumer expenditure.

The RBI statement admits that consumer prices continue to be under pressure. Food inflation is still at an intolerable level. The psychological danger facing the nation is the subtle change in official circles on the level of the new normal for inflation.

While paying the usual lip service to containing the ‘perception of inflation' in the 4-4.5 per cent range, the new normal for inflation is 6.5 per cent expected for the current year.

Under such circumstances, one wonders how inflation expectations can be contained or anchored. Once upon a time, the RBI heroically declared in its Annual Report that living with inflation was no option. Obviously, to modify Bob Dylan, “For the times they are a-changin”!

Growth of money supply

The one saving grace in the RBI statement is the moderation in the indicative projections for money supply, deposit and non-food credit growth at 15 per cent, 16 per cent and 17 per cent respectively.

In the past, in arriving at the annual growth of money supply, the RBI used to multiply the GDP growth rate by the income elasticity of demand (IED) for money and add another 5 per cent to accommodate inflation.

On the last occasion, the figure for IED was around 1.4-1.5. Using these figures and the assumed GDP growth (7.3 per cent) and inflation rate (6.5 per cent), the RBI should have normally estimated M{-3} to grow by16.5-17.5 per cent.

Mercifully, it has kept it down to 15 per cent. Considering the astronomical figures of money supply over the years, even a second decimal growth can make a difference to the absolute amount.

The RBI argues correctly for the pass-through of the rising oil costs to administered prices. It says: “Although the likelihood of a pass-through depends on the strength of the pricing power in the economy, which is currently abating, the risk of a pass-through cannot be ignored altogether.”

One can work out how much of a one per cent increase in oil prices will impact general prices due to the cascading effect by using the inter-industry tables (Leontief matrix). The erstwhile Econometric Division of the Bank used to do the exercise in the past. We should be prepared for the consequences.

Impact of cut

Will the rate cut, a signalling instrument, help the average borrower either in the rural or urban areas?

It is not of relevance to agriculture and exports which enjoy interest subventions. Although the farm sector contributes less than one-fifth of GDP, it accounts for nearly 70 per cent of the population in terms of livelihood.

Now the inflation rate has shown a trend of rural prices rising even more than in urban areas, thanks to the Mahatma Gandhi National Rural Employment Guarantee Scheme, which is basically issuing doles without much impact on production or productivity.

The central bank can do nothing about this matter. Since interest constitutes a small proportion of the total cost of production in the industrial sector, as revealed in the company finance studies, the rate cut is not going to result in any reduction in the prices of manufactured goods.

On the other hand, it will mean an addition to the profits of enterprises.

If the reduction in the rate provides an incentive to investment through a rise in the internal rate of return, it would have served the purpose.

The sector that may benefit is the construction industry, apart from personal loans. Ceteris paribus , the sector may get a push if home loans get the benefit of the reduction in rate.

But, the caveat is that the prices of apartments have reached such high levels, especially in cities, that a 50 basis point decline in the rate may not be enough to help even a working couple pay the equated monthly instalments.

We have heard about “The Impossible Trinity and The Trilemma” in policy making. There is also the conflicting quartet of monetary, fiscal, exchange rate and debt management policies.

Public debt management can no longer be dealt with as a residual in policy making but has to be integrated with the rest of the economic policies. The massive programme of market borrowing by government, expected in the current year, will prove a challenge to the central bank to maintain stability in the markets.

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