Just five months ago, the International Monetary Fund (IMF) in its annual country report on India assessed that inflation in India had been contained, and that the medium-term prospects for the economy were good. Now, headline inflation has doubled and the Reserve Bank of India (RBI) governor has suggested that true inflation may be even higher — even without factoring in the suppressed inflation due to price controls on petroleum products. The Economist, in a cover story, has suggested that failing to deal with inflation in emerging economies will put future growth at risk, with the experience of the developed world in the 1970s “great inflation” as a lesson in what to avoid. What should RBI do?
The obvious answer is to raise interest rates and choke off demand for credit. It is always possible that new inflation shocks will force RBI to do so and, indeed, it may act before this article is published. But I would argue for holding off on further monetary tightening.
The reasons are as follows: In addition to interest rate hikes, RBI has aggressively raised the cash reserve ratio for banks, with the latest increase just taking effect. Credit growth has already slowed quite a bit: Though it is still slightly above target, my guess is that it will come down further. Foreign capital inflows seem to have cooled off as well. Growth in industrial production has already come down dramatically. Finally, the factors leading to the recent upsurge in inflation, namely, jumps in the prices of oil, metals and food, have probably reached their short-term limits. They may still work through the economy, but, given the tightening that has already taken place, my guess is that increases in raw material costs will further dampen industrial growth.
Essentially, a dampening of expectations with respect to real rates of return on investment will trump inflation expectations. Signals of those expectations are mildly pessimistic, but do not indicate panic. RBI has not released the results of its inflation expectations survey at the time of writing, but 10-year government bond yields have crept up only marginally in recent weeks.
Support for a “do-nothing” position comes from an unlikely quarter. Joshua Felman, IMF resident representative in India, by examining recent weekly data, suggests that inflation may have peaked, though the year-on-year figure may climb for a while longer.
If we put this information together with what we know about lags in the impact of monetary policy and the likely stabilization of commodity prices, then a wait-and-see attitude makes sense. I would also draw a lesson from the 1990s episode of RBI tightening, which led to a greater slowdown than might have been optimal. Lost growth is costly, and provided inflation does not get out of control, India may be at a point where keeping investment and growth high may be worth a little bit of extra inflation in the short run.
This is heresy for inflation targeters, and seemingly at odds with the concerns expressed in The Economist. The problem with the latter is that it mixes up all kinds of stories and experiences in the emerging economies pot. The Bric (Brazil, Russia, India and China) grouping is catchy, but hardly useful for policymaking in the individual economies. Russia certainly seems to have problems with its money supply growth, and all the macroeconomic management challenges that come with being an oil exporter. In its more nuanced analysis of the Bric countries, the IMF country study pointed out that Brazil and India have already put more emphasis on containing inflation than Russia and China. Finally, the analogy with the 1970s industrial countries may be misleading because of the different structures of cost pass-through, including powerful labour unions.
One place The Economist is right is in assessing the consequences of US Fed policy. The US Fed has cut interest rates dramatically. In doing so, it was motivated by the need to avoid a crisis in the financial system. But that was best handled by specific liquidity enhancing measures, which were also used. The US macroeconomic slowdown is certainly a cause for concern, but my sense is that the Fed has cut rates too much, in its desire to protect domestic growth.
It would be ironic if this policy, by exporting liquidity, were to force emerging economies to sacrifice their own growth.
Two other general prescriptions are also right for India. One is fiscal tightening, and the other is allowing greater exchange rate flexibility. Both of these measures would allow RBI greater room to manage monetary policy in a way that does not kill growth.
And the main policy prescription, which has nothing to do with monetary management, should never be lost. Removing rigidities and unnecessary controls in India’s internal and external markets, and making it easier to do business and make productive investments are the only sure-fire methods for making people’s lives better in the long run.
The government could use the current inflation scare to reform in a positive direction, rather than regressing with added controls.
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at firstname.lastname@example.org