Going overboard on inflation targeting

The majority view of the RBI’s Monetary Policy Committee seems to be based on a fundamental misconception that supply-side conditions determine output and there is inflationary demand in the economy despite a negative output gap.

Output cost

A large amount of research, including the RBI’s own, shows that in India interest rates affect output first and inflation much later. Moreover, the effect on output is many times that on inflation. This large impact on output and minor impact on inflation implies that output is demand-determined.

Growth rates have slowed by about 2 per cent per annum since tightening started in 2011. Policy aggravated, instead of countering, low world demand during this period. Average annual growth was 8.5 per cent over 2003-04 to 2010-11 but 6.7 per cent till 2017. A minimal estimate for output lost over 2011-2017 is ₹20 trillion GDP or about $400 per capita. India’s poor can ill afford such a loss.

A glide path was adopted for inflation targeting, with food price led inflation to be brought down slowly, in order to minimise output sacrifice. But favourable commodity price shocks brought inflation down faster since 2014. The RBI, however, did not believe the fall would be sustained, and did not bring interest rates down commensurately, thus imposing unnecessary growth sacrifice, while raising rather than lowering inflation expectations. Shifting to a neutral stance was a communication error.

If rates affect output more than inflation, targeting the latter is most effective through guiding inflation expectations. It need not take a long time to reduce inflation expectations if, as in India, they are dominated by commodity prices that are softening for secular reasons. An oil price rise will be capped because of shale oil production and renewable energy alternatives.

Operative constraint

Recent data also shows demand to be the operative constraint. There is excess capacity in industry, slow credit and employment growth. Spliced annual savings and investment ratios to GDP show a slowdown in both, led by investment, indicating a fall in demand was the driving factor. That the current account deficit fell despite a fall in exports also points to low domestic demand. Lower oil prices reduce exports as well as imports.

There is a view that supply-side factors such as bank NPAs and corporate debt are constraining credit and growth, not interest rates. But banks are holding G-secs ten per cent in excess of regulatory requirements because of lack of credit demand. Firms’ external and domestic market borrowings are also low. Foreign banks hold the largest share (above 40 per cent) of G-secs. Private banks lend largely to retail. Private corporate sector savings are almost at peak 2007-08 ratios of 9.4, after falling in the middle — not all corporates are indebted. When interest rates were cut following the global financial crisis (GFC) private investment increased sharply by 2011-12. Debt had been high since 2009-10 but did not hold it back.

The interest elasticity of consumption demand is also rising. Properly estimated, it is as high as in advanced economies. The weight of consumer durables in the new IIP is 12.84. A rise in demand and capacity utilisation would induce investment.

Fiscal consolidation driven by fear of outflows and ratings agencies added to demand compression. The new committee on FRBM in deriving a future path assumes the real interest rate will exceed the growth rate! This cannot be true on a high growth catch-up path.

Latin American crises dominate rating agencies’ views on emerging markets. Indian differences such as higher savings rates, the working population, and growth potential are not adequately factored in. The counter-cyclical space painfully created by macro stabilisation since 2011 is not being used. This is counter-productive since a higher income is the major variable that rating agencies consider in an upgrade, and is the first priority for foreign inflows.

Pro-cyclical bank regulation

Bank regulation has also been strongly pro-cyclical. Indian banks that were untouched by the GFC, and are subject to strong prudential regulation, are being forced into a developed country mould, with standards even tighter than Basel III, IndAS, to be implemented one year before it is internationally, and strict provisioning. Forcing banks to pass through policy rate cuts does not work when higher provisioning and weak balance sheets raise their costs. Making liquidity available is important.

In India where bank credit and deposits are the major avenues for finance and savings respectively, unlike the US where markets dominate, we cannot afford to destroy our banks. As it is, markets have not been able to replace shut development banks. There was poor sequencing in the action on NPAs. Resolution should have first priority in Indian conditions, where infrastructure is under-provided.

But recognition was implemented first without fund infusion in a high interest rate regime that added to corporate debt and NPAs. Debt ballooned because of delays in resolution. Most of the firms are not zombies that must die, but were laid low by external shocks and policy failures.

Even so, owners must also bear risk and put in adequate equity. Bank recap bonds are an excellent move. But demand stimulus has to complement them. In addition, both banks and invested debt inflows will get capital gains as G-sec interest rates fall. Borrowing costs and fiscal deficits can also then fall in a virtuous cycle.

Overlooking employment

The MPC’s decision to raise real repo rate to 3 per cent suggests it took the view that investment slowdown was reducing future capacity, so growth should be further reduced, to maintain the output gap. It was relying on the weak aggregate demand channel to make doubly sure of 4 per cent future inflation, going against the glide path’s philosophy of minimising output sacrifice. It ignored the possibility that stimulating demand could have raised investment. There was space since it was well within its target band — inflation was even below 4 per cent. It must be the only MPC in the world that does not even mention unemployment, and that too in a year when the CMIE estimates 2 million jobs were lost. Fundamental misconceptions have a tendency to be data resistant.

The literature on inflation targeting specially mentions the importance of flexibility, of reflecting society’s priorities, and of avoiding being labelled an “inflation nutter”, in order not to lose society’s support and eventually damage independence. It also makes it clear that inflation targeting must take into account many variables. Making room for supply shocks is feasible and need not disturb inflation expectation as long as communication is clear. Accountability is necessary with independence. Since the RBI has the dominant vote, the responsibility rests with it.

The writer is a part-time member of EAC-PM. The views are personal

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