The rupee’s internal value

The value of the rupee in the foreign exchanges appears to have stabilised, having settled at a higher exchange rate. Now that the external value of the rupee has been bolstered, the RBI has expressed its intent of turning to stabilise the rupee’s internal value.

Though much to be desired, it would be reasonable to imagine that this is going to be a harder nut to crack for our central bank than was the exchange rate. For close to three years now the economy has experienced near double-digit inflation. In fact, India’s policy establishment has presided over a swing, from the promise of double-digit growth to the reality of double-digit inflation.

Engineering excess demand

While the RBI may have expressed its intention to stabilise the rupee by wringing out inflation, it is not clear how it can do so. Announcing a policy of inflation targeting gives the impression of high-minded resolve, but for practical purposes it only amounts to a statement of intent. We have had by now the closest we can get to a controlled experiment in the field of economics.

In a span of some 18 months starting March 2010 the repo rate was raised 13 times in succession with next to no impact on the inflation. There need be no surprise in this outcome at all. We have a complete understanding of the kind of inflation at play in India in recent years and what is needed to contain it. The clue is to be found in the price of agricultural goods rising faster than the general price level. Agricultural goods are getting relatively more expensive, or in the economist’s jargon its real price is rising. We might think of this as reflecting a chronic excess demand, as it has lasted for over three years by now, though we ought not to see this as shortage in the normally understood sense of the term.

In any case, from the observed pattern of price movement it is obvious that the inflationary impulse can be traced to the agricultural sector. Mostly in these past three years, the inflation rate has been led by the price of cereals, namely, rice and wheat. Ironically, this is happening at a time when the government sits on mounds of the stuff, with stocks exceeding its own notified buffer-stock norm. So the excess demand is engineered as it were by the government, a shortage being created by an active purchase of grain in the open market even as public stocks accumulate. The instrument used to achieve this is the procurement price.

Mounds of foodstuff

But a conventionally understood shortage of agricultural commodities does exist with respect to vegetables, pulses, milk, meat and fish. Unlike in the case of cereals for which data of reasonable accuracy exists, we have little to go by in the case of these. However, we know that their demand is income-elastic and it is unlikely that supply has kept pace.

Being perishables they cannot be stored, except perhaps onions and that too for only a while, and their prices are determined by supply and demand. It would be reasonable to infer from the continuing price rise that supply is not keeping pace with demand. As part of the flimsy food-supply chain we must include infrastructure ranging from roads to cold storage.

Whatever the cause of the rising price of agricultural commodities, and we have identified two of them at work at present, it is clear that the role of monetary policy in curing this type of inflation is limited. At least it cannot come without a cost. Controlling inflation that is due to supply constraints without a reduction in output, or at least a slowing of growth, is next to impossible.

Monetary policy enthusiasts speak of “anchoring inflationary expectations”. In the case of the exchange rate this is possible if the central bank has enough reserves and is determined to use them. An egregious instance in the history of central banking when this failed was when the Bank of England was worn out by George Soros who launched a speculative attack against the pound sterling.

In the normal course, though, central banks, including the RBI, can stem such attacks with their dollar reserves.

However, for a central bank to try and anchor inflationary expectations in a commodity market is an altogether different matter. It does not hold stocks of vegetables or fish. In fact, they are perishables and not much stored in India in any case.

Now, not even the interest rate, which can influence stockpiling, is a particularly relevant instrument. As for the cost of holding stocks of cereals, the Food Corporation of India can afford to remain impervious to the interest rate as the cost of holding stocks just gets shown as ‘food subsidy’ whether or not a single grain of rice reaches the consumer.

But the interest-rate mechanism can well work for output growth in sectors of the economy outside of agriculture. Production takes time, and early-on costs are compounded at the short-term rate of interest to determine the cost of production of a unit of final output.

Manufacturing firms pass on interest-rate increases to the consumer. Demand for their output either declines or at least slows as the central bank raises the interest rate to check inflation.

The combination of higher price of food and slowing income growth in the economy is likely to slow the demand for non-food while having little impact on inflation as the price elasticity of food is low.

We observe this sequence of events play out in the Indian economy over the past two years, when manufacturing output has more or less ground to a halt but inflation has continued unabated.

Govt game plan

We are now able to see that the inflation we are currently experiencing lies beyond the control of the RBI, and a hawkish monetary-policy stance only constricts growth while having a minimal effect on inflation. Its task is not just unenviable but rendered next to impossible when we factor in the government’s game plan as revealed in a pronouncement by one of its leading ministers.

He had recently boasted on television that it is the aim of the government to ‘shift the terms of trade in favour of rural India’. Subsequently, a weary central minister for food supplies had also resorted to this very explanation as the price of onions doubled, arguing that farmers would now be better off.

First and foremost, as we have seen, shifting the terms of trade towards agriculture is inflationary. Second, the overwhelming majority of rural inhabitants are net purchasers of agricultural goods, and a shift in the terms of trade to rural India impoverishes them.

So, a central bank can only watch in shock and awe as the government tries to shift the terms of trade towards agriculture, contrary to its (RBI’s) pronouncements on anchoring inflationary expectations.

Even a good monsoon can do little if the government continues to raise procurement prices or does nothing to strengthen the supply chain. Easing supply-side bottlenecks alone can make a difference to the present inflationary impulse.

(The author is Director, Centre for Development Studies, Thiruvananthapuram. Views are personal. )

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