Ashima Goyal

Growth vs inflation control

ASHIMA GOYAL | Updated on March 12, 2018

Growth slowdown has not affected wage levels, which continue to rise on the back of food inflation.

Monetary tightening reduces growth more than inflation when the latter is driven primarily by food prices and supply-side factors.

The recent softening trend seen in headline wholesale price inflation (especially its ‘core’ component) and also in global commodity prices demonstrates yet again the criticality of supply shocks in determining the performance of the Indian economy.

The combination of low growth and sticky or gradually declining inflation we are now seeing is well explained by demand contraction along an aggregate supply (AS) curve that is almost flat, but subject to repeated shifts – due to changes in expectations and cost variables. Upward shifts raise the general level of inflation. With such a combination, demand contraction generates a high growth cost, but without much effect on inflation.

The International Monetary Fund’s latest World Economic Outlook has pointed to the AS curve becoming flatter in advanced economies, which means inflation responding less to cyclical factors. This is partly because of better anchoring of inflation expectations, so that wages (and, therefore, price levels) do not respond much to changes in employment rates as before.

SHIFT VARIABLES

In India, too, average wage levels now respond less to cyclical variables such as growth. Rather, they respond more to ‘shift variables’. That especially includes food price inflation which shifts the entire AS curve upwards. A shifting yet more-or-less flat AS curve is more natural in a country that has large numbers of its people transiting from low to higher productivity employment.

It follows from this that the primary policy objective in India should be to try and affect the variables that lead to shifts in the AS curve. Credible anchoring of wage-price expectations is, no doubt, necessary after a period of sustained high inflation, but this requires only a small excess of potential over actual output.

A large negative output gap (i.e. actual output being less than full-capacity output) helps only if wages and other costs fall steeply as growth falls – which is not the case in India where wages respond less to growth than ‘shift’ factors such as food price inflation. It makes the case all the more strong to have lower agricultural support price increases, for instance, to anchor overall inflationary expectations.

CASE FOR RATE CUTS

Since recent inflation numbers have turned out less than what were forecast, a reduction in policy rates by the Reserve Bank of India (RBI) is compatible with anchoring inflation expectations. The announcement of an expected WPI headline inflation of five per cent in March 2014 in the RBI’s annual monetary policy, below the current six per cent levels, will also help anchor expectations.

On the whole, inflation is coming down irrespective of the indices that one may refer to, while growth remains weak. What is particularly worrying is that lead indicators for services, which have a significant share in India’s GDP today, are negative. Expenditures such as on purchases of homes, vehicles and consumer durables are quite interest-rate elastic. Lower loan rates will certainly help here, apart from also improving banks’ asset quality as borrowers experience less payment stress.

Keeping these in view, the latest repo rate cut by the central bank was more than warranted. While the RBI has resorted to significant cash reserve ratio cuts and open market operation injections, its liquidity adjustment facility or LAF window has continued to be in deficit mode for the past many quarters.

A major reason for this has been the large cash balances maintained by the Centre and the States with the RBI. Since under current accounting norms, balances, whether of cash or of food, do not show up in deficits until they are spent or used, governments have an incentive to carry large inventories. This will change if interest costs or revenue foregone on account of governments’ holdings of inventories are treated as expenditure.

Apart from availability of liquidity, its cost also matters. A fall in borrowing rates through the LAF will reduce cost of funds for bank, thereby helping them lower loan rates.

RISK FACTORS

At the same time, since CPI inflation and food inflation remain high, policy rate cuts have to be small and conditional upon future price falls. Thankfully, inflation levels are coming down and these could be further aided by projections of bumper harvests worldwide and hopes of a normal monsoon in India. While banks are constrained to fully pass on the benefits of policy rate cuts because of slow deposit growth – making it difficult to reduce the rates on these – they may still be able to do so once savers see better real rates with inflation falling.

The same goes for rural real wages, which are still rising. But the rate of increase is only about 2.5 per cent now, compared with 20 per cent levels as an initial reaction to spiralling food prices. The current account deficit (CAD) remains uncomfortably high, requiring structural changes that reduce relative production costs of domestic exports and import substitutes. Softening oil and gold prices can improve the CAD in the short-term, giving further leeway for rate cuts.

In the Indian context, good macroeconomic coordination would involve proper allocation of stabilisation responsibilities between the Government and the RBI to achieve the best growth-inflation outcomes. Poor coordination occurs when monetary tightening by the RBI as a response to food price inflation hits manufacturers just when their costs are rising. Or government transfers create demand for a diversified food basket, which then further pushes up food prices, without addressing marketing and other restrictions in agriculture that constrain supply response.

Examples of good coordination are removing unnecessary restrictions and other institutional inefficiencies that raise costs to allow monetary policy to support demand, just as lower cash balances by the Government with the RBI would improve liquidity management. Reduction in fiscal deficit would help to the extent it reduces transfers and artificial demand created for supply-constrained non-tradable goods. Here, pressure from rating agencies may have helped. That, along with the strategic decision to cap petroleum subsidies, will go some way in meeting deficit targets despite election pressures.

If the supply-side is important for controlling inflation, but the latter is regarded to be primarily the RBI’s responsibility, which can only tame it through demand contraction, the result is real coordination failure. It, then, entails unnecessarily large output sacrifice to curb inflation – which is what we are seeing.

(The author is Professor of Economics, Indira Gandhi Institute for Development Research)

Published on May 14, 2013

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