We economists are an arrogant lot. If reality doesn’t match with our theory, we find faults with reality.
And so it has been in India for the last several months. Having decided that if it is food inflation then it must be supply shocks, we spent the last year in collective denial that it was loose fiscal and monetary policy pushing demand beyond the economy’s capacity that was the primary driver of inflation, exacerbated by the supply shocks and not the other way around.
And so both the government and the Reserve Bank of India (RBI) kept assuring us that we should not worry needlessly. If the record harvest didn’t tame inflation, base effects would. RBI did raise rates, in fact eight times, but with none of the urgency or aggression that was warranted. Secure in the same belief, the government went on pumping more fiscal stimulus into the economy.
With every passing month as the data unerringly surprised expectations on the upside and as the authorities kept raising inflation forecasts and exhausting one ad hoc explanation after another, these assurances sounded just a little less convincing and just a little more unreal. Instead, tolerating high inflation for this long only hardened expectations, pushing the economy into a generalized inflation spiral as it inevitably does.
More ominously, core inflation appears poised to accelerate further with inflationary expectations hardening by the month, crude prices remaining elevated and leading indicators such as the purchasing managers’ output price index underscoring that even the past rise in input prices have not been fully passed into manufacturing inflation.
Yet, some are still arguing that monetary tightening could cripple growth. Nothing could be more disingenuous. We know at least since 1972 (Bob Lucas’ paper) that the growth-inflation trade-off exists only when expectations are stable, not when they are rising as now, or falling as in Japan in the 1990s. Empirically, we know at least since the late 1980s (Stan Fisher’s paper) that such trade-offs exist only when inflation is low, not when the quarterly rate of core inflation is over 11%. Instead, at these levels, bringing down inflation is essential to safeguard future growth by sacrificing near-term growth.
It is against this context that the central bank came good in its credit policy today. It shrugged off its institutional inertia of moving in predictable 25 basis points (bps) steps, raising rates 50 bps. One basis point is one-hundredth of a percentage point.
The central bank acknowledged that inflation was nowdriven by demand factors and inflationary expectations were coming unhinged, and laid to rest the growth-inflation trade-off by making inflation control and safeguarding medium-term growth its primary objectives rather than worrying about near-term growth. These are the clearest signals yet that RBI is not afraid of turning on the heat to curb inflation and that we should expect similar aggressive tightening, which most likely will be needed, in the coming months.
Also important was the introduction of the marginal standing facility, which would allow banks to repurchase at any time 1% of deposits at 100 bps above the repo rate. With this change, the banking regulator has now a much better chance of keeping the overnight call rate within 100 bps of the policy rate—the repo rate, something the central bank has struggled to do in the absence of conducting daily open market operations.
That apart, raising the savings rate hopefully is a harbinger of deregulating interest rates on savings accounts. I am sure that there are many good reasons for continuing with our paternalistic attitude to protect the less sophisticated investors such as pensioners and the poor, but presuming them to be naïve is both untrue and disrespectful.
Jahangir Aziz is senior Asia economist, JPMorgan Chase.
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