Pronouncements of the inflation rate having peaked in May were based on the expected price of food, and had not factored in the politics of administered pricing in India. Now that a rise in the domestic price of oil has finally been announced on Wednesday, a fresh bout of inflation has been set off. This is bound to keep alive a renewed pressure to define the Reserve Bank of India’s mandate solely in terms of low inflation. While the inflation scare is rich with pickings for those arguing for this, its nature, namely, that it’s commodity price-led, leaves the case for a pivotal role for the central bank a little less secure. Two issues need to be reckoned with when evaluating the argument for a central bank, independent or not, being given low inflation as its sole mandate. First, the relationship, if any, between central bank action and inflation. Second, the evidence provided in support of the proposal needs assessment.
The central bank can control inflation directly only if it causes it. If this is so, the solution to the problem of inflation is straightforward. Control the money stock, implicitly within the ambit of the central bank, and you control the inflation rate. Now, nothing stands in the way of the central bank achieving the inflation rate it chooses. But, this is too neat a story, as many practitioners of the art of central banking have discovered. In the real world, the stock of money is not what the central bank has chosen to shower upon the economy from a helicopter, but what has been demanded by financial institutions, mostly banks. Commercial banks demand money as the private sector and the government demand money for their daily monetary transactions.
Thus, we find that the stock of money, and by implication its growth, is not determined by the central bank independently of the demand for it. The variable that central banks can and do influence is the nominal rate of interest. Once the rate of interest has been fixed, the central bank must supply the quantity of money demand generated by the markets. The central bank has lost control of the money stock, and even if money alone causes inflation, the central bank has no direct means to combat it. The central bank may yet be able to control inflation indirectly via the interest rate mechanism. As the interest rate is varied, investment may be expected to determine the level of economic activity via the rate of profit. Less activity following a rise in the interest rate affects the demand for goods, creates unemployment and lessens demand-pull inflation. Note from the channels through which such anti-inflationary policy works how indirect the mechanism is.
In India, where we are witnessing supply shock-driven inflation, monetary policy can lower inflation only by engineering slower growth of manufacturing. We know this from the episode in the mid-1990s when in a bid to lower inflation, which was partly driven by rising procurement prices, monetary policy got so tight that it snuffed out the private sector’s vigorous early-supply response to the reforms.
Those arguing for an independent central bank view a certain historical episode as clinching their case for the importance of an independent central bank focused on low inflation. It is pointed out that after a serious inflation scare in the 1970s and very early 1980s, monetarists had come to govern much of the Western world, which led the move to making independent the central banks of some of the most important economies of the world. Since the 1980s, inflation has abated, too, at least till very recently. The champions of central bank autonomy treat this as evidence of the independence of central banks, or at least the adoption by them of a low-inflation objective.
This is not convincing. It has been demonstrated that for Britain at least, the decline in inflation came about via declining commodity prices rather than the monetarists’ strategy of creating unemployment. Global commodity prices, including oil, in the 1980s were at their lowest since the Great Depression. Another reason in the Anglo-American world at any rate, is the decline of union power. Inflation has been licked because the unions have been.
More recent versions of the argument for an autonomous central bank with a low-inflation mandate invoke the idea of expectations to generate low-inflation outcomes. The argument goes like this. Inflation is driven by expectations of economic agents — firms and workers — and their expectations are driven by what the central bank will do. If the central bank has been given a low- inflation mandate, agents will expect low inflation and factor it into their wage and price demands. As the inflation rate is only an aggregation of these wage and price demands, expectations of low inflation feed into a low-inflation outcome. This argument is far too neat for its own good, however. Note that the deus ex machina is the expectations-formation mechanism. Why should agents believe that the now autonomous central bank can peg the inflation rate and adjust their own demands accordingly? Presumably because they learnt their economics at the feet of Milton Friedman in Chicago. Assume, however, that they studied at the Indian School of Economics in Bharat where they were taught, very sensibly, that the inflation rate is driven by the rate of growth of agriculture. No amount of central bank independence will lead them to expect a low-inflation outcome when they see agricultural output growing sluggishly! This would be a perfectly rational expectation on their part. Now, expected inflation will remain high and, going by the theory, so would actual inflation.
Systemic domestic inflation can only be countered by productivity growth. Where inflation is imported, as with the price of oil now, some belt-tightening will be needed. This inflation will have to be endured. The central bank can lower inflation only by engineering recession.
Pulapre Balakrishnan is an independent economist. His writings can be accessed at www.pulaprebalakrishnan.in. Comment at firstname.lastname@example.org