Ashima Goyal

Coming to grips with inflation

ASHIMA GOYAL | Updated on August 16, 2011


Monetary policy is moving rather too fast on the inflation front, while government action on the supply side continues to be glacial. The RBI did wait for supply-side improvements before reverting to its historical sharp tightening.

Small steps add up to a large stride, especially if they follow each other in quick succession. A large stride after a series of small ones makes it a giant stride. The latter can be dangerous at a time of great uncertainty when time brings in vital new information.

If monetary policy is thought to act with a lag, as the cumulative effect of past steps is beginning to slowdown the economy, why is policy aiming for a further decrease many months into the future?


Policy affects forward-looking expenditure components, such as investment, today. This reduces capacity tomorrow.

Just as the government taxes only salary earners, high interest rates tax the most dynamic interest-elastic component of the economy. Other risks are emerging, as the widening interest differential raises short-term foreign debt in volatile markets.

An argument for higher rates is firms' profits are still high, implying they have pricing power that needs to be taken out. But many firms become cash-rich during a high growth phase, so as interest rates rise they make money from higher nominal interest rates, while large debtors become insolvent.

Another argument is real loan rates that affect investment are low while real interest rates are negative for savers.

The absence of inflation-indexed instruments for savers is a major shortcoming. But in India investment tends to be low when real interest rates are low. The reason is episodes of low real interest rates have coincided with supply shocks when costs are rising for both firms and consumers. Larger instalments on loans reduce consumer durable demand. As demand falls production and capacity expansion is reduced.

Does falling demand reduce inflationary expectations and therefore reduce the prices firms set today? It may not if the impact of output on costs is low and costs themselves are rising, with interest rates contributing to those costs. A large output sacrifice is then required for a small effect on inflation.


Does falling demand reduce employment and wages thus reducing costs and prices? The Graph, based on ASI (Annual Survey of Industry) data, shows that in the downturn that followed peak interest rates after the East Asian crisis, manufacturing real wages did not fall — these are indexed to inflation.

But non-manufacturing real wages which are not indexed fell. India's large informal labour was forced to bear the brunt of the slowdown.

Will that happen again as growth and employment rates fall sufficiently? It may not, because now informal wages are also partially indexed through schemes such as NREGA. Employment growth will fall but sticky real wages can keep up cost pressures.

Informal wages especially are indexed to food prices, since food is a large part of the budget. So what can anchor inflationary expectations is a softening of food inflation.


While monetary policy is moving too fast, government action on the supply side continues to be glacial. NREGA needs to be focused on creating assets. Officials do implement a clear target.

If creating assets, such as water recharge, had been given as their objective to all the officials involved, employment would also have been created as a by-product.

Instead, NREGA functioned as a leaky dole. States have competitively raised minimum wages in the scheme since the Centre foots the bill. They should be told they will have to bear the cost of any increase in wages.

Multi-brand FDI in retail, the only measure on which there seems to be some action, will take long to fructify. Domestic changes to improve inter-state connectivity and competition in agricultural marketing can be faster, and would make FDI more effective when and if it did come in.


There have been international pressures on India' s overheating and the need for a sharp rise in interest rates. A July Economist article, based on IMF research, put India among “sizzling 7” countries, on highly contestable grounds.

The IMF's credibility is low. It was wrong about India in 2008 and about East Asia earlier. A biased management makes it harsh on emerging markets and soft on advanced countries. So the advice imposes excessive employment sacrifices on emerging markets while pumping up bubbles in advanced countries that are bursting all around us.

But the IMF was probably preaching to the converted, since our policymakers have always reacted strongly to inflation.

The norm was to tighten in response to commodity price shocks, although even the most conservative inflation targeting bank responds only to demand shocks. Our response to inflation is higher than any Taylor rule.

This time the RBI did wait patiently for supply-side improvements, and has reverted to its historical sharp tightening only after the Government did not, or could not act.

(The author is Professor of Economics. IGIDR, Mumbai.

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Published on August 11, 2011
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