Confusion remains over the reasons why inflationary pressures in India have not abated. The spread of inflationary pressure from just a basket of commodities and food items to general manufacturing seems to have caught even the Reserve Bank of India (RBI) by surprise. What has caused this acceleration in “core inflation”? Answering this question is key to evaluating RBI’s response and to understanding the desired future course of policy action.
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There are at least four hypotheses doing the rounds. The first is that supply shortages led to a spike in food prices that is now baked into inflationary expectations. In this view, the solution lies in dealing with supply bottlenecks, not in raising interest rates. The second is that there is an inflation growth trade-off such that higher growth is sustainable, but at a higher equilibrium rate of inflation. For a shining India, an inflation rate higher than its historical average is the new normal. The third is that the impact of rising oil prices has been transmitted to the Indian economy. In this view, there are no good monetary policy choices— should high international prices of oil persist, we are headed for a period of stagflation. The fourth is the great QE2 theory. In this view, waves of international liquidity crashing into emerging markets in search of superior returns are causing currencies to appreciate and/or economies to overheat.
None of these hypotheses is fully credible. The evidence that supply bottlenecks were widespread enough in 2008-09 to cause a sharply elevated inflation rate for a broad basket of food items is not compelling. There is also no reliable evidence that we can buy higher sustainable growth with a higher equilibrium inflation rate. While domestic inflation rates and international oil prices appear correlated, domestic controls on petroleum prices make the pass-through effect less obvious than it seems. As for the impact of capital inflows from abroad, these did contribute to a surge in domestic liquidity in the run-up to the 2008 Lehman crisis, but have not been a factor since.
A good old-fashioned monetarist framework is the most useful for understanding what is happening. The simple premise of the quantity theory of money is that for a given velocity of money, the higher the growth rate of money supply relative to the real gross domestic product (GDP) growth rate, the higher the inflation rate. In this framework, ensuring that monetary aggregates stay within an estimated equilibrium growth rate is key to controlling inflation. But estimating this target growth rate depends on the predictability of the demand for money, which in turn depends on the stability of velocity.
Most emerging markets experience prolonged periods of financial deepening, which is to say, periods of declining velocity of money such that the non-inflationary equilibrium stock of broad money (M3) relative to GDP keeps rising over time. Thus in India, between 1997 and 2010, the ratio of bank deposits to GDP rose steadily from about 40% to more than 75%; inflation at the same time was a reasonable 5%, even as bank credit grew at an average rate of 19% a year. But something changed in 2010. Even though credit growth remained within the historical range deemed compatible with non-inflationary GDP growth, the average inflation rate accelerated to 9.5%, well above the average of the previous decade. Something has caused the predicted relationship between M3 growth and GDP to break down. Starting in 2010, the M3/GDP ratio came down for the first time in over a decade (see chart). It seems that the economy was experiencing a bout of financial shallowing. Since then, the income elasticity of demand for broad money has fallen instead of rising, suggesting a degree of disintermediation from the formal banking and financial systems.
But what could have caused this? I think the culprit is the type of fiscal stimulus unleashed in the wake of the 2008 crisis. In response to the crisis, the government aggressively expanded social spending through schemes such as the Mahatma Gandhi National Rural Employment Guarantee Scheme. There is no data on how much “leakage” there is in such spending. But by all accounts, there has been substantial diversion of funds, which over a period of 12-18 months have found their way into the cash economy rather than being intermediated through the banking system. This phenomenon has caused a liquidity shortage in the formal banking system, even as currency in circulation has grown at a faster pace than commensurate with the demand for cash balances. This is what has caused inflation to accelerate.
Under the circumstances, as long as the government remains unwilling to rein in its subsidy-related spending and reduce the associated leakages, the burden of action will fall upon RBI. Ideally, RBI would want to reduce the growth in currency without choking credit off-take. In this context, raising the interest rate on savings accounts was exactly the right policy measure. This should attract more deposits into the banking system from the cash economy, making more liquidity available for banks to lend. But should the behaviour of small depositors prove to be rate-insensitive, RBI would have no choice but to further drive down the demand for credit. They would be forced to crowd out private investment demand to accommodate lower quality government funded consumption spending. That would be unfortunate. I hope the finance minister takes note.
Rajiv Lall is managing director and chief executive officer IDFC Ltd
Graphic by Sandeep Bhatnagar/Mint
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