If you repeatedly say something at variance with the truth, that something sometimes becomes the truth itself. This “principle” — if we can call it that — as everybody knows, has been used repeatedly in the political sphere; not only in India, but globally for devious ends (Joseph Goebbels comes to one’s mind immediately).

That principle now seems to be playing itself out in the economic sphere in India. The reference is to the so-called disconnect between the Government of India and the Reserve Bank of India as regards their goals and strategies. In the economic sphere, though, the supposed “disconnect” should actually become the truth for the overall common good!

Where’s the disconnect?

The Indian Government has repeatedly complained that the RBI is “unconcerned” about GDP growth, since it has been refusing to cut interest rates.

The Finance Minister even said that he would walk alone to push growth. He also said that price stability cannot be the only objective for a central bank, which has to be mindful of employment and overall growth also.

The RBI, on the other hand, says that while it is mindful of growth, it cannot sacrifice its inflation objectives. That is, it says that it will keep interest rates at whatever levels are necessary to produce low inflation.

One would infer from the statements of the two parties that the central bank with its strong anti-inflation policy has produced sustained low inflation, but killed GDP growth in the process. That is, the RBI has kept interest rates so high that economic activity has ground to a halt.

Is that the reality? No. The reality is that the RBI has kept interest rates low and sustained it over a period of time. Economic activity has nevertheless decelerated. In fact, one can say that it is because of the RBI keeping money so easy that “real” economic activity has decelerated.

For, too easy money over too long a period of time is producing price-level led economic growth (or nominal GDP growth) and not real output growth.

While nominal GDP grew 350 per cent between 2000 and 2012, real GDP grew only 120 per cent in the same period — implying average annual (overall) price increases of as much as 12 per cent. And, cross-country experience shows that once high inflation and inflation expectations set in, the initial benefits of producing a “surprise” inflation to power real output growth are well and truly lost. We then land in what is called as “stagflation”.

The pick-up in growth in the earlier part of the last decade was in that “surprise” inflation period. But, we are now well entrenched in a period where high inflation expectations have also become solidly entrenched. In other words, there can be some initial negative correlation between (low) interest rates and growth. But, if you persist with soft money beyond the economy’s output capacity, the correlation turns positive.

The graph will disprove the Finance Minister’s statement that the RBI has kept interest rates high. We have particularly mapped the last year’s yields since the complaints about the RBI keeping interest rates high were loudest in this period.

Will the Government or the RBI please tell us how sovereign yields — which set a benchmark for all interest rates — have been declining even as the RBI is supposed to be in the midst of a great anti-inflation campaign?

For a longer term perspective, note that Indian benchmark yields, after hitting a trough of 5 per cent early in 2004, have bucked up to the 8 per cent levels since then. But, most critically, yields are not being allowed to rise much above 8 per cent in the last 7-8 years. The chart shows a small time capsule of the last 7/8 years and is a good example of the RBI’s long-term easy money stance.

(Ten 10 year yields till June 2013 are shown in the graph. Post-June 2013, one has to see if the RBI carries through its recent liquidity tightening measures to its logical conclusion.)

Expectations are key

In summary, inflation expectations of both households and businesses have adjusted sharply upwards in the past decade.

This is having two simultaneous drag effects — one on the external BoP and another on local investment confidence/intentions and actual investments. That is the background to the serious rupee problem in our forex markets and the continued deceleration in (GDP) output outcomes.

With adjusted inflation expectations, households are demanding positive real compensation for their savings.

Since that is not being provided by the RBI’s “financial repression”, the savings are getting diverted into gold and real estate. Financial savings of households have registered a steep decline in the past five years.

The financial repression has only reinforced Indian households’ inherent bias for gold and real estate. Combine that with our refusal to permit POL demand to be elastic to prices. That is a toxic mix for the rupee’s external value. No point in blaming “speculators” — either here or in the Non-Deliverable Forward (NDF) markets.

At the corporate level, the adjusted inflation expectations have meant that past investments made on the expectation of “high real returns” are under-performing. The corporate sector is now confronting all-round price level/cost increases, which means that its profitability is under stress. In the “surprise inflation” period in the earlier part of the last decade (say up to 2005-06), it benefited from only “relative price increases” — that is, price increases only in some goods and services and, therefore, its profitability was “good”.

In other words, the RBI has allowed relative price pressures to morph into serious aggregate price pressures in the past decade. If investments are to be revived now, India probably has to produce still higher inflation so that expected real returns turn “attractive”.

That is really the “accelerationist hypothesis” trap envisioned by Milton Friedman for economies which try to exploit an imaginary growth/inflation trade-off. India seems to be in such a trap now. No easy way out of that. That is probably what the RBI governor designate Raghuram Rajan had in mind when he said no magic wand solutions exist for India.

(The author is a Chennai-based financial consultant

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