With the Reserve Bank of India (RBI) hiking lending rates and the cash reserve ratio (CRR) in response to surging inflation, most pundits are likely to conclude that it has acted decisively to control inflation. But, as I will explain, RBI’s monetary policy, on an absolute basis, continues to be far too lax and in spite of the seemingly hawkish moves, inflation will only accelerate further in the months ahead.
Some “Economics 101” would stand us in good stead for us to understand what constitutes sound monetary policy. The definition of inflation is the “supply of excess money and credit within the economy relative to the goods and services produced, resulting in higher prices”. So, it is to be understood that the cause is “excess money supply” (i.e., M3) and the result is “higher prices” (i.e., CPI). Confusing the symptoms for the causes, as most central banks do today, is an issue that the “sound money” economists have always warned against. Therefore, when we try to control inflation by price controls (such as not allowing a pass-through in oil prices), it should be recognized that we are treating the symptoms and not the root cause. Consequently, a non-inflationary monetary policy would have to ensure that the growth in M3 is not more than the expected growth in GDP and interest rates are “real” to encourage adequate savings that would be required to achieve productivity improvements through investments.
So, how has RBI functioned on the above two parameters, of M3 growth and interest rates? Despite the multiple CRR hikes over the last few years, our M3 growth continues to be well above 20% and real interest rates continue to be negative, with the inflation rate at 11% (which in any case grossly understates the inflation experienced by consumers). So, the current set of tightening measures is much too feeble to contain inflation within the economy. And with RBI insisting on not allowing the rupee to appreciate in the forex markets, we are set for a prolonged period of double-digit inflation rates.
At least for the last five years, RBI has consistently underestimated inflationary signs within the economy. When Y.V. Reddy began his tenure as RBI governor, one of his first objectives was to bring down the CRR to 3% in the medium term, from the then levels of 4%. After five years, today the rates are more than double of what they were then. My criticism is not that RBI did not bring down the CRR as it had promised, but that it failed to read the inflationary signs even when it was obvious, if not “proactively”. CRR at 4% was too low then as 8.75% is too low today.
Not only did RBI not understand the consequences of its loose monetary policies all these years, it has also failed to read the commodities cycle correctly. From the bottom in the year 2000, when oil was at about $10 a barrel, it has taken RBI a full eight years and a near 1,300% increase in energy prices to recognize that this increase may not be temporary. While credit must be given for recognizing the trend at least now, RBI has failed the subsequent Noah test, i.e., predicting rains does not count; building arks does. So, having recognized the enormity of inflationary pressures, why the baby steps?
What should RBI do?
I think we are well past the stage in which RBI can pretend that inflation will come down over the next few months—either due to its hawkish pronouncements, good monsoons or due to the marginal measures adopted. If RBI is interested in protecting the integrity of the currency, then it should hike the interest rates and the CRR by several hundred basis points (of course, I would have to agree entirely with my Austrian-minded colleagues and readers who insist that the concept of fractional-reserve-banking based on CRR itself doesn’t make any economic sense in the first place. But I will reserve that commentary for a later date).
The effect of the economy would not be very pleasant. But let the chips fall where they may and we can start rebuilding our growth on the foundations of sound money and true savings (rather than the funny money that we have today, where RBI creates capital from thin air). That would be a more sustainable growth platform than the monetary policy-induced boom-bust cycle which we have today. It would have been nice if we could have started in this direction a few years ago when the inflationary pressures were much less extreme; but waiting for a few years to start on the sound money path would be much worse.
Surely the above is not likely to be a very popular measure. But the job of a central banker isn’t exactly a popularity contest either. As I have explained in the very beginning, basic economics tells us that when central banks print more money, prices rise as a consequence. So, Reddy describing inflation at 9% as “unacceptably high” a few weeks ago is not very different, in an economic sense, from a thief who tries to escape a chasing crowd by pointing “thief” at somebody ahead of him.
It’s time RBI recognized and got rid of inflation; after all, it is causing every bit of it.
Shanmuganathan N. is director of Benchmark Advisory Services. Comments are welcome at email@example.com