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Where monetary policy fails

Where monetary policy fails
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First Published: Thu, Mar 25 2010. 09 14 PM IST

Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Thu, Mar 25 2010. 09 14 PM IST
Inflation happens when there is a mismatch between demand and supply of output. From a layman’s perspective, managing inflation, therefore, is to manage the demand-side factors, the supply-side factors, or a combination of both, affecting availability of output ( gross domestic product, or GDP). Demand-side factors are consumption expenditures, investment expenditures, government expenditures, and demand for exports and imports. Supply-side factors, on the other hand, take into account availability of foodgrains and manufactured items, besides looking at the availability of fuel items such as oil.
Given this information, when the Reserve Bank of India (RBI) raises interest rates (repo and reverse repo rates), it is seen as an attempt to bring down inflation by trying to control the demand-side factors. A higher interest rate, which most often translates into higher loan rates, can control consumption expenditures (contributing close to around 65% of economy-wide demand), and by raising the cost of capital, can also bring down investment expenditures. For example, the economic expansion of 2005 that lasted until the early part of 2007 was mainly because of increase in consumption expenditures. The tighter credit policy of April 2007 was influential in reducing inflation rates from around 6.7% to around 3.5% within a quarter. In fact, there are studies indicating the existence of association between broad money supply (M3) and the Wholesale Price Index (WPI).
Illustration: Jayachandran / Mint
But what happens if the cause of inflation is supply-side factors and/or speculation? Supply of output can get affected because of drought (especially when around 55% of our agricultural produce depends on rainfall), capacity constraint (lack of availability of physical infrastructure) and because of speculation.
For the third quarter of 2009-10, agricultural and allied activities have grown by -2.8%. This might explain the high food price inflation that we see today.
Though investment expenditure in India contributes to around 33% of GDP, more than half of this investment comes from the household sector. That is, a relatively small portion of our investment (than the stated 33%) is actually used for building new factories, adding to existing capacity for factories and to build physical infrastructure—something that will ease capacity constraint.
Finally, though some studies have spoken about lack of association between spot and future prices (in terms of their movements) in the agricultural commodities market (that is, spot and futures prices in India do not react similarly in the event of any new information), there is a need to examine whether futures trading in foodgrains and in commodities leads to inflation.
There is evidence about speculation leading to high futures prices. The high oil price inflation during early part of 2008 is a testimony to that. However, this high oil price could not be sustained as, after a point, there were no buyers for oil futures, and the oil price crashed. Since futures prices for agricultural and commodity items in India are integrated with global futures prices, and there is a convergence between spot and futures prices, one can very well argue that speculation in the agriculture and commodities market is also contributing to inflation.
The idea behind introducing futures trading in agricultural commodities was to guarantee price certainty to the farmers. However, for agricultural items in general, during any given day the number of contracts traded by traders (which also includes speculators, hedgers and arbitrageurs) is at least 12-15 times higher than the number of contracts traded by farmers. That is, farmers seldom participate in the futures market for agricultural items. As a considerable number of traders can be speculators, it is necessary to examine the association between the Consumer Price Index for Industrial Workers (used as a measure for cost of living index) and futures commodity prices for agricultural items. Alternatively, there is also a need to figure out how to increase farmers’ participation in the commodity futures market.
From the policy perspective, if the cause of inflation is supply-side factors, and RBI in its effort to curb inflation follows a tighter monetary policy, then it might lead to stagflation (a combination of higher inflation and unemployment)—something none of us would like to see. What is required is the use of supply management policies such as investments in building suitable infrastructure, focusing on developing new technology to improve agricultural productivity, better water management to reduce volatility of agricultural output, and, more importantly, curbing speculative activities to ensure stability of growth in the agricultural sector. Food price inflation hurts the poor consumer more than the rich consumer.
What is also needed is better policy coordination between the ministry of finance and RBI. Though Pranab Mukherjee was praised for his last Budget, measures such as slashing of direct tax rates for income up to Rs8 lakh and imposition of Central excise duties on diesel/petroleum items will actually contribute to inflation—something that RBI officials can do little about.
Nilanjan Banik is associate professor at the Institute for Financial Management and Research, Chennai. Comments are welcome at theirview@livemint.com
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First Published: Thu, Mar 25 2010. 09 14 PM IST