Cash, not credit, drives consumer inflation. The RBI’s reliance on consumer prices as an inflation anchor is flawed
The RBI has stirred the discussion pot by linking monetary policy action to consumer price index (CPI) inflation. Quite clearly, there has been some acceptance of the recommendations of the Urjit Patel Committee Report, which has strongly advocated this line of action.
The theoretical justification is that CPI inflation is used all across the world for targeting inflation and logically we should do the same. It is accepted that we could fine-tune the present composition of the CPI in case it does not reflect the true nature of retail inflation, but ultimately it is this index which should be the guiding factor.
It is, therefore, interesting to look at the CPI composition and see whether interest rates have a bearing on the prices of the respective components.
It is important to note that in the West households use credit cards for virtually all daily transactions and hence their cost of transactions varies with the interest rate structure. This is not the case in India.
Further, there is less distinction between wholesale and retail prices in developed markets as the value chain is truncated, unlike in India, where due to structural factors there is a gap between the two. For non-manufactured food, the value chain could be between 5-6 levels, where cumulative costs and margins get embedded. A lot of consumption takes place in rural India where cash transactions dominate.
Around 75 per cent of the CPI would generally not be associated with the use of credit. Food items, which account for nearly half the weight of the index, are daily consumables and would be driven by cash purchases.
For the same reasons, interest rate changes will not impact expenditure on fuel (9.5 per cent CPI weight), housing (9.8 per cent) and transport (7.6 per cent). Bills for fuel and lighting at home are not financed by any institution. Rentals for housing have to be from one’s income, while transport costs too cannot be leveraged.
Education and medical expenses, if backed by bank loans, are normally undertaken because they are essential. Therefore, such spending is not likely to depend on the cost of credit. For clothing, credit cards may be used, especially if it is for purchase of branded clothing.
Even purchases in malls tend to be made more on the basis of debit cards, where the question of interest payment does not arise.
Myriad forces
Prices of transport and housing have less to do with demand as fares move up when fuel prices increase. Rentals move up or down based on the price of property and general economic conditions.
In case of food, while excess demand would push up prices, such demand is normally driven by cash purchases and can be linked with increasing wages. And, there is the Veblen effect — where goods are procured to make the individual look better, higher cost of credit is unlikely to be a deterrent. For the miscellaneous category, which includes purchase of consumer goods and automobiles, interest rates could have a bearing on purchase decisions, though both these industries are witnessing de-growth.
So, even for this balance 23-25 per cent of index, which could possibly be subjected to monetary policy impact, higher interest rates may not lower demand for such funds.
There could still be a counter argument that Indian society is progressively aping the West and using cards and loans often to satisfy its needs. To check on this, the credit profile of banks can be looked at closely.
Borrowing trends
Today, the share of personal loans is around 18 per cent in gross bank credit, which includes mortgages accounting for around 9.5 per cent. The rest of the credit is to agriculture, industry and services, which cannot be related with the CPI.
Further, credit cards (0.5 per cent), loans against consumer goods (0.2), education (1.1), and automobiles (2.3), the ones that can be related to the CPI, would account for a sum of not more than 5 per cent of outstanding credit. Even if all purchase decisions in this category are being guided by monetary policy action, not more than 5 per cent of credit would be affected.
Does this mean linking interest rates to CPI is not valid? Calibrating interest rates with CPI inflation is certainly a strong line for policy action if it is defined as a tool to align nominal interest rates with positive real returns.
One of the challenges for the economy has been a decline in financial savings as negative real returns have worked against instruments such as deposits. Today, a one-year deposit gives a return of around 8.5 per cent, which adjusted for 10 per cent, CPI inflation yields a real return of negative 1.5 per cent.
This has been a concern for the RBI. Therefore, increasing interest rates to protect real rates is a logical reaction from the central bank. But using this tool to bring down CPI inflation may not quite work out.
How then are we to react to the use of CPI as a guiding milestone for monetary policy? Tuning interest rates with CPI inflation will help to a large extent to protect savings, but not perhaps in bringing down inflation.
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