Mumbai: After two weeks, India’s food inflation is back again in double digits. Weekly fluctuations in food prices may not be always be very material but as last month’s WPI numbers show inflation has become generalized and is no longer restricted just to food articles.
Doubtlessly, this will put the spotlight on the limited success of the Reserve Bank of India (RBI) in combating inflation for well over a year. Subbarao’s reluctance to deviate from a gradualist approach to tackling inflation led the Wall Street Journal to wonder aloud after the January policy review if he is a hawk, dove or chicken.
This is indeed a dramatic shift in perception about RBI from the heydays of 2009, when India and its central bank were the toast of international policy makers, as a 23 March Economic Times article by MC Govardhana Rangan points out.
Rangan argues that Subbarao’s policy stance has a Greenspan-like touch in its predictability. Comparisons with Greenspan would probably be the last thing any central banker would want to hear!
But is it fair to judge monetary policy without taking into account the role of fiscal policy?
In a recent post on iMFdirect, (Read blog post) celebrated macro-economist David Romer writes that one of the key points of reasonable agreement among economists after the crisis is:
The impact of a change in fiscal policy is extremely dependent on whether monetary policy is able to respond, and on how it responds if it can.
We would like to invert the argument to point out that the success of monetary policy depends as much on its own stance as it does on fiscal policy.
The fiscal deficit target for next year at 4.6% is by all counts commendable and if realized would be a big step to combat inflation. However, many doubt if the target is actually achievable as Jehangir Aziz puts it eloquently here.
If oil prices stay at current levels, Pranabda would probably need Harry Potter’s wand to achieve that target.
Now consider growth: a target of 9% is not exactly anti-inflationary. Supply-side bottlenecks may be partly responsible for inflation but faster growth without easing those constraints will cause only more, not less inflation. And if budget projections are to be believed, capital expenditure by the government is going to come down from 13.4% of total expenditure to 12.7%.
It is like a car with a fraying engine that is trying to speed faster.
So why does the government not acknowledge this and aim for a moderation in growth till it is able to ramp up investments?
Kaushik Basu’s argument in this year’s Economic Survey was:
In designing inflation control measures it is important to be aware that sudden, sharp policy induced contractions in demand can cause unemployment to rise.
He goes on to argue that the trade-off between inflation and employment escapes public awareness as employment statistics come with long intervals unlike inflation numbers.
Basu’s point that a hard landing would cause unemployment and misery is true but it actually makes the case for a moderation in growth to avoid a hard landing later.
Besides, one can argue that the cost of unemployment has to be balanced against the cost of inflation to evaluate whether on balance the welfare loss of employment is still greater.
Secondly, high inflation often leads to what is termed as ‘demand destruction’, exactly what oil prices are threatening to do to the global recovery. If high inflation erodes purchasing power and could slow down consumer demand as some surveys indicate, then inflation rather than policy tightening becomes a bigger threat to growth and employment.
Basu also argues that prices tend to be higher in economies where growth is higher. Empirical evidence for such a simplistic relation (which economists term the Balassa-Samuelson effect) has been hard to come by. Casual empiricism also suggests otherwise — we need not even look beyond our immediate neighbourhood to find such evidence.
Justin Yifu Lin, chief economist at the World Bank cites China’s example in a recent speech to illustrate how high growth is attainable with low inflation. Read speech
A fiscal stimulus aimed at increasing railroads, port facilities and other infrastructure allowed China to raise its annual growth rate to 10.9% in 2003-10 from 9.6% in 1979-2002. They achieved it without raising inflation beyond 5% unlike earlier decades when 2-digit growth rate was always accompanied by a 2-digit inflation rate, said Lin.
Basu’s contentions may be debatable but the elaborate justification of high inflation could perhaps be an indication that the fiscal stance would be tolerant of high inflation.
One reason for this could be that though politically inflation is a problem for the government, financially it is not.
As long as nominal GDP is going strong, tax revenues would grow. More importantly, the government being a net borrower would benefit from inflation, at least in the medium term. Not for nothing do they call inflation a tax!
However, as the government’s stance is known only once a year unlike RBI’s policy reviews that have a six-weekly frequency, fiscal policy’s contribution to inflation might continue to escape public awareness, slanting discourse on the subject.