Context:
- The Reserve Bank of India (RBI), the institution charged with the job to contain inflation, decided to stop raising interest rates.
- This was quite odd because since May last year, the RBI had been exchanging jabs with high inflation, trying to bring it down close to RBI’s target level of 4% by repeatedly raising interest rates. It was almost as if the RBI suddenly decided to stop boxing and instead stand in one corner of the ring.
Some background:
- The RBI is one of those central banks that are charged with targeting a certain level of inflation, come what may. It primarily does this by raising interest rates in the economy.
- Higher interest rates drag down economic growth because loans of kinds become costlier. In essence, and this is the key point, the RBI hits overall demand to bridge the gap between what is demanded and what is supplied, thus bringing down prices.
- In other words, a central bank’s single-minded focus on targeting an inflation rate might imply overall economic growth contracting.
- For instance in the US, the Federal Reserve has been hiking interest rates, thus dragging down overall demand and economic activity, in its bid to achieve its target of 2% inflation. However, in doing so, the Fed is running a very high risk of pushing the US economy into recession. While a recession is not what the Fed may want, it is supposed to not care beyond a point because it has to achieve the 2% inflation target.
- In RBI’s case, it is even starker. Unlike the Fed, which is charged with achieving 2% inflation and full employment, the RBI’s main job is to achieve the 4% target.
Why was RBI’s decision surprising?
- While inflation had abated a bit, it was nowhere near close to that target. In fact, the last two readings (January and February) were 6.5% and 6.4%, respectively. To be sure, the RBI’s legal mandate gives it a leeway of +/- two percentage points either side of 4%. That means RBI has a comfort zone of 2% to 6% within which inflation must remain.
- On the face of it, the RBI — more precisely the six-member Monetary Policy Committee that has an equal number of members nominated by the RBI and the Union government — (unanimously) decided that it was a good time to stop throwing and assess the effect of the previous punches. The RBI Governor repeatedly emphasised that “the decision to pause on the repo rate is for this meeting only”.
- But this too was odd. If your punches are landing, you might as well finish the job while you can. Why run the risk of giving a breather to your opponent? This is especially true because inflation has been getting the better of the RBI since late 2019 . What’s more, even by RBI’s own calculations, it won’t be able to bring inflation down to its target rate of 4% for another couple of years. That’s five years of inflation besting the RBI, And these are the base case assumptions; things get worse if crude oil prices jump for some reason or there are unseasonal rains or some new geopolitical tension crops up.
- To make the situation even more peculiar, the RBI presented a rather optimistic picture of the economy. The GDP estimate for the current financial year was revised up and the inflation forecast was reduced. The GDP growth rate’s upward revision was most peculiar since almost all private estimates are significantly much lower than RBI 6.5% forecast and, thanks to the worsening global growth forecast, most experts are revising down their projections for India, not revising up.
- In the commentary following the policy announcement, and regardless of what the RBI Governor said about this pause being only for this meeting, most economists openly stated that this was the end of rate hiking cycle for the time being. In fact, some even started penciling in an interest rate cut later in 2023.
What could be the real reason for the RBI to pause?
- The question is: How can RBI be so far behind achieving its inflation target of 4% and yet be so comfortable as to pause when there’s no clear evidence that inflation is no longer a concern.
- Of course, one would have to wait for the minutes to get a better understanding of RBI’s rational but a look at the past two minutes is quite revealing.
- In the last meeting in February, RBI raised repo by 25 basis points by a majority of 4-2. One of the two dissenting members (both were government-nominated ones) was Prof Ashima Goyal.
- While opposing the hike, Prof Goyal made some very interesting points that not only show the limits of RBI’s strategy of hiking interest rates to contain all kinds of inflation but also question the very efficacy of the inflation-targeting system for a country such as India.
Some of her key points were:
1) She felt that while RBI has been doing its bit, it may be time for fiscal policy (read the government) to help out in bringing down inflation. “The large commodity component in India’s consumer price basket, and pockets of supply constraints, respond better to fiscal action,” she wrote. As such she suggested it may be time for things like a cut in excise taxes, fuel prices. In other words, she felt under the circumstances — as in, when inflation is pushed up by supply bottlenecks and costs instead of being pulled up by demand — monetary measures were not enough to contain inflation and needed fiscal (relating to government’s taxes and spending) action.
2) Secondly, she hit at the root of the whole justification why central banks raise interest rates even when inflation is driven by supply-side bottlenecks, stating “…there are still little signs of wage or demand-led second round effects on inflation…” . On paper, even though raising interest rates does not boost the supply of food (say onions) and/or fuel items (say crude oil), central banks do this to crush demand for goods and services and thus, ensure that people’s expectation of future inflation do not soar. But this may not be happening to the extent imagined in the first place.
3) Lastly, and most significantly, she warned against raising interest rates because they can not only hurt growth but also be counter-productive from the perspective of containing inflation per se. “Excessive front-loading of rate hikes carries the risk of over-shooting that is best avoided for compelling reasons in the Indian context: First, raising real policy rates [that’s nominal interest rates minus inflation] to reduce demand has a stronger effect on growth than it does on inflation. Second, since there are more lags in monetary transmission in India, over-shooting can have persistent deleterious effects here, including instability. Third, macroeconomic stability improves most rapidly if real interest rates are kept smoothly below growth rates and counter external shocks. The Indian economy is well-poised to achieve this combination and to reduce its chronic underemployment,” she wrote.
Since the RBI shifted from a 4-2 majority to a 0-6 unanimity between February and April when there was still no evidence of inflation coming down sustainably, it makes sense to presume that the view held by Goyal resonated with the other members.
A big question-mark on the efficacy of inflation-targeting
A key part that is not covered in the minutes pertains to the kind of inflation India has been facing since late 2019. Contrary to the notion of an overheating economy, which experiences inflation because demand outstrips supply, in India’s case it is the supply costs and bottlenecks that have created inflation, not an economy running hot.
In fact, this is no coincidence. A September 2022 academic paper, titled “What Drives Indian Inflation? Demand or Supply”, written by Ashima Goyal and Abhishek Kumar, concludes thus: “Inflation is mainly driven by supply shocks and excess monetary policy reaction hurts the real economy. Excess tightening would not improve [RBI’s policy] credibility if excess demand due to supply-side deterioration causes inflation persistence.”
Two things stand out. One, in India, inflation is often driven by supply-shocks originating and operating through the food economy. Two, merely raising interest rates doesn’t help beyond a point; indeed, it is counter-productive. “Goyal (2015) supports flexible inflation targeting but at the same time points out that its over-strict implementation proved very costly and contributed to significantly lower employment growth since 2011,” she writes.
Wider policy implications
Just as policymakers in India’s RBI are reconsidering whether further rate hikes will contain inflation or make matters worse by destroying growth and worsening inflation, similarly, there is global debate about the policy prescription of “inflation-targeting”.
Many economists, such as Pulapre Balakrishnan of Ashoka University, have repeatedly warned against the use of inflation-targeting by the RBI.
“The RBI has been off-target (4%) for a very long time. The notion that inflation targeting works in India is a joke,” he said over a phone interview.
Instead, he pointed to another way of viewing inflation and inflation control.
This is called the “structuralist model”.
“In developing economies often agriculture productivity faces constraints and its growth is unable to keep pace with the rest of the economy. As a result, agricultural prices rise and overtime these higher prices permeate through the broader economy since the non-agricultural sectors such as industries practice a ‘cost+’ pricing,” he explained.
Raising interest rates doesn’t help matters in such a scenario. “The only way inflation can be handled is by the government increasing supply. In the short-term, imports are the only option.
What about the RBI is such a model? “The RBI has zero role. Raising interest rates can slow down the spread of inflation but eventually it comes at the cost of the economy’s output,” said Prof Balakrishnan.
In other words, if inflation is driven by supply factors, raising interest rates could lead to a situation akin to the operation being successful but the patient [the economy] being dead.
Given the fact that in India inflation is mostly due to supply factors and that RBI’s recent record at meeting the inflation target has been woeful, should India reconsider the inflation targeting mandate for RBI?
Source: Indian Express