Losing the plot on inflation
Business Standard, 7 May 2008
The recent inflationary spiral, and the nasty responses of the government to it, are acutely painful. This reminds us of the need to establish a sound monetary policy framework, which is primarily focused on delivering low and stable inflation.
How did we get in this mess, and how would a reformed monetary policy framework make a difference? We got into this mess largely because of faulty monetary policy.
Governor Reddy likes to say that all possible measures will be used to combat inflation. Unfortunately, his actions are very different from his words. One critical lever that can combat inflation - rupee appreciation - has been used in the wrong direction by RBI. When the US dollar crashed, and many international product prices rose when expressed in dollars, we blindly hung on to the 40 rupees a dollar pegged rate. In the process, we imported inflation. RBI has prevented rupee appreciation; it even artificially engineered a small rupee depreciation which actually worsens inflation.
The short-term rate is now roughly zero in real terms, which is expansionary monetary policy. In September 2003, M3 growth was at 12% on a year-on-year basis. From December 2006 onwards, M3 growth crossed 20%. In early February 2008, M3 growth was as high as 24%. This configuration of currency, interest rates and money supply is an inflationary one. We would be very surprised if inflation did not flare up with this configuration of monetary policy.
Many people are emphasising commodity prices, food shortages, etc. as the source of inflation. But inflation is a broad macroeconomic phenomenon and one should be skeptical about the role of individual sectors in influencing inflation.
To illustrate the ability of monetary policy at coping with the same international commodity price situation, examine the well-run central banks of the world. When you landup at the Bank of England website, right on the front page (http://www.bankofengland.co.uk/) it tells you that the legislative target for inflation is 2% and the actual inflation rate is 2.5%. Most Indian politicians would be thrilled to be in that situation. It is a reminder of the power of a well structured monetary/financial policy framework.
There is a gulf among economists on the question of growth versus inflation. Economists schooled before 1975 tend to think that there is a tradeoff between growth and inflation: that a certain tolerance of higher inflation is okay since could support higher growth.
There was a sea change in the profession in the mid 1970s. We now know that there is no long-run tradeoff between growth and inflation. All mature market economies are now hawkish on inflation, for we now know that planning of households, business confidence, high investment and high GDP growth are all supported by low and stable inflation. Reflecting this fact, one by one, the central banks of the world have shifted away from messy monetary policy frameworks to a focus on inflation. Those in India who talk about a tradeoff between growth and inflation are drawing upon the academic scribblers of more than 30 years ago.
The right way to think about inflation involves two key elements. First, monetary policy must focus on forecasts of inflation and not present or past inflation. In countries where monetary policy works well, it impacts on inflation over a horizon from 6 to 18 months, hence decisions about monetary policy must be made based on forecasts of inflation over the coming 6-18 months. It is important for central banks to be hawkish to anticipated changes in inflation. The second element is GDP growth : monetary policy must respond (in a softer way) to future GDP growth.
"Inflation nutters" are criticised for being obsessed with inflation and nothing but inflation. This is not a description of the new consensus in monetary policy. Sensible central banks care about forecasts of future inflation - they are hawkish about future inflation and nip the problem in the bud ahead of time - and they also care about output. Critics like to setup a straw man of an inflation nutter in order to discredit modern monetary policy. Central banks that do inflation targeting inflation take into account the expected growth rate. No one is proposing that growth will not be a variable in the picture.
In terms of monetary policy framework, the front page of the Bank of England website is crystal clear on the 3 fundamental facts: What is the inflation target, what is the actual inflation, and what is the policy rate. In India, unfortunately, we are in a badly structured monetary policy framework where objectives, instruments, transparency and accountability are all broken.
In terms of objectives, RBI likes to engage in mumbo-jumbo, talking about many objectives in obscure language and being accountable for none. In a democracy, every government agency should be clear and transparent on what it does and why. There is a need to switch from mumbo-jumbo to clarity.
In terms of instruments, RBI has prevented the development of the Bond-Currency-Derivatives Nexus (BCD Nexus). The BCD Nexus is required in order to have an effective monetary policy transmission - the market process through which changes in the short-term policy rate reach out and influence the entire economy and change future inflation. With the RBI approach to the BCD Nexus, monetary policy is enfeebled.
This understanding is not new. Over the last five years, correct diagnoses of the problems facing monetary and financial sector policy has been available. An extensive process of public debate, leading up to the Percy Mistry and Raghuram Rajan committee reports, has offered a clear understanding of the problems and the strategies for solving them.
Unfortunately, 1970s vintage economics has ruled the roost. Not only has progress not taken place, in some areas reforms were actually reversed. These mistakes have real consequences. Now the chickens have come home to roost, and we are down to the depressing litany of government actions attacking speculators, hoarders and exporters as the way to stop inflation. The use of 1970s vintage monetary economics has resurrected 1970s vintage policies on inflation control.
In the depths of the pain of this inflation spiral and the nasty things which are being done to check it, the Ministry of Finance needs to establish a monetary policy framework where the central bank is responsible for delivering on an inflation target. This requires achieving international best practices on objectives, instruments, transparency and accountability.
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