Which inflation concept is right for RBI? Financial Express, 19th July 2012

The reference made to the ‘right concept of inflation’ by the RBI Governor really raises the broader issue of how monetary policy should be structured. There are basically two goals for a central bank: growth and inflation. If growth is to be superseded by inflation, then it is necessary to be sure about what kind of inflation we are targeting considering the multitude concepts of inflation in the country. There are basically two ways of looking at monetary policy targeting. The first is to look at a particular inflation number and work towards bringing it down. The other is to look at it from a theoretical or ideological standpoint and then use this basis for targeting inflation. This becomes important because, on its own, the inflation number we are targeting may not be influenced by monetary policy—which appears to be the case today as food inflation cannot come down by keeping interest rates high. We should bring in the theoretical concept of real interest rates to provide justification for such action. First, we need to understand the power and transmission mechanism of monetary policy. The armoury of monetary policy consists of various tools by which we are able to lower interest rates or cost of credit or augment the supply of funds with banks for lending purposes. Therefore, any measure invoked finally influences the bank’s ability to lend, which would be in terms of lendable resources with them or cost of lending. By altering these two, RBI can control the growth of credit, which, in turn, affects the demand for funds. The basic premise of monetary policy here is that when rates are increased, people borrow less and, hence, reduce demand for goods. How does this work? There are two sets of borrowers—individuals or retail—who borrow to buy houses, automobiles or consumer goods, which pushes up demand for the same as well as related inputs. The other is enterprise, where industry borrows to create capital goods, which, in turn, pushes up prices when supplies are not matched. Therefore, the transmission mechanism of credit policy is straightforward. This being the case, it helps to reduce excess demand forces, thus pushing down prices. Now, if we look at the structure of inflation in India, there are three components in the WPI where primary, fuel and manufactured products constitute the index. The primary product prices are driven by supply-demand factors. However, demand is rarely led by borrowed money as banks do not lend money for buying food. The same holds for fuel products, and hence irrespective of what we do to interest rates, these prices have their own determination mechanism. Where policy matters is in the case of prices of manufactured goods, which is also called core inflation. Here, RBI is actually lowering the demand for goods, which could lead to prices coming down. If people buy fewer houses now, the demand for what goes into houses like cement, steel, electric products, etc, would be reduced. So what should RBI target? From the point of view of efficacy of monetary policy, higher rates will work only if we are tackling core inflation. The other two components are either structural or driven by supply factors over which RBI has little control. The same holds for CPI, which has more consumer goods and services, and where interest rates matter very little. In fact, once we move from producer prices (which is largely in the WPI) to consumer prices (which is in the CPI), then the power of monetary policy declines. If this is so, then raising rates on grounds of inflation cannot be justified as even if rates are lowered to, say, zero, people cannot borrow to demand food or fuel products and hence should not affect these two components of inflation. Therefore, RBI may have something else at the back of its mind when talking of interest rates. The clue is really real interest rates. With WPI inflation at 7.3% and CPI inflation at, say, 10%, the real cost of funds is in the negative zone with the repo rate being 8%. If one goes back to the Chakravarty Committee of RBI in 1986, it had recommended a real return of 2% to the deposit holder ideally. Using this logic, deposits should give a nominal return of 9-10% going by WPI and 12% by CPI. Otherwise, they are actually not being compensated at all for inflation or are suffering from money illusion. One can hence surmise that when RBI says it should not be looking at just core inflation, which is 5% today, but overall inflation, the thought at the back of the mind must be the entire structure of real interest rates in the economy, and the reference is not confined just to the effectiveness of monetary policy. By not keeping rates high today to adjust for inflation, the cost of funds gets distorted and borrowers gain while savers lose. The lending rate in real terms could be close to negative if the base rate is juxtaposed with, say, the CPI rate, which distorts the money market. Therefore, it may be argued that this rationale must be floating somewhere at the back because RBI would otherwise not have any other justification in terms of transmission of monetary policy measures to the economic system for its current stance.