Photo: Pradeep Gaur/Mint
Photo: Pradeep Gaur/Mint

India’s damaging inflation debate

The virtuous cycle of lower trend inflation leading to a structural decline in interest rates remains elusive

All eyes are on Reserve Bank of India (RBI) governor Raghuram Rajan’s last monetary policy meeting, scheduled for 9 August. Given the tone of the incoming inflation data, almost no one expects a cut in the repo rate. There is, however, considerable uncertainty about the post-Rajan monetary response function because of the unhealthy speculation about his successor.

The significance of the upcoming meeting owes to it potentially—and worryingly—marking the end of the short Rajan era of monetary and fiscal discipline that enhanced and entrenched macro stabilization. He also undertook a path-breaking upgrade in the monetary policy framework. It is still premature but, looking ahead, the monetary-fiscal mix could become expansionary relative to market expectations prior to Rajan’s unexpected announcement to not seek an extension.

The upcoming policy meeting takes place in the context of meaningful shifts in global and domestic parameters relative to the last meeting in early June. Globally, the post-Brexit price action has been unexpectedly favourable towards emerging markets, including India. Crude oil prices have declined and capital inflows have picked up, facilitated by expectations of expansionary policy measures in key developed economies for combatting stalled growth. The next interest rate increase by the US Fed has also been pushed back.

Domestically, the monsoon news has been favourable, but perhaps not as great as some had wished. Progress on the goods and services tax is welcome and money market liquidity has improved substantially, though transmission by banks remains weak. The growth outlook remains for a consumption-led gradual and uneven pick-up. Despite the public capex push and sharply higher foreign direct investment, revival in private investment isn’t imminent; this shouldn’t be surprising. Most importantly, consumer price index (CPI) inflation has been a concern, moving up to be just shy of the 6% mark in June. Core inflation remains worryingly sticky.

The inflation debate in India remains a victim of confusion, innocence, ignorance, and spin doctoring. It also has several nuances one rarely finds in other Asian economies. I have previously argued in this newspaper that revising up the acceptable threshold of inflation to facilitate rate cuts will be admitting to failure to deliver lower inflation (see: Inflation targeting and credibility, 13 July).

The confusion is mainly because the government plays up the too-good-to-be-true official gross domestic product (GDP) growth figures while being anxiously silent (but surely worried) about the absence of meaningful job creation. It is no one’s case that the GDP data is being rigged. However, the government should offer some insights about the missing job creation if the economy is indeed growing at 7-7.5% as officially reported. Either the GDP data is overstating growth (highly likely, in my view), or something structural has changed that even high growth doesn’t create sufficient jobs in India. Either way, some clarity from the government’s economic guides would be welcome.

Unfortunately, the debate on inflation and growth is entrenched as one or the other, and RBI is the proverbial bad guy because it is not cutting interest rates aggressively. This is odd since it is following an appropriate path for interest rates most likely to deliver inflation based on a target set by the government.

As the impact of the 1991 reforms showed, an emerging economy can have a virtuous combination of lower trend inflation and higher sustainable growth, which will also boost job creation. Such a game plan was expected from the Narendra Modi government. The government has undoubtedly undertaken several meaningful steps, but the big picture of the multiplier impact of low and stable trend inflation on economic growth remains elusive. Instead, there seems to be an increasing near-term tilt towards expansionary policies—always an easy political option.

Empirical evidence of good monsoons lowering food inflation is less robust than the popular rhetoric that makes that claim. Still, inflation is likely to ease later in the year and RBI’s target of 5% by early 2017 should be achievable. The challenge is going to be thereafter: the 4% target for early 2018 is ambitious but only because the government isn’t going all out to achieve it. Instead there is loose talk about easing the inflation target or appointing a dovish governor to do the needful.

A few columnists, including some economists, and newspaper editorials still argue that the CPI should not be the inflation yardstick for setting policy interest rates. Suggestions vary from returning to wholesale price index (WPI), some average of WPI and CPI, or a core measure of CPI. For the record, all these options were explored before zeroing in on the CPI. The recent amendments to the RBI Act enshrine the CPI as the legally mandated inflation yardstick for monetary policy.

Rather than addressing a shortcoming that is keeping inflation higher than it should be, a lazy suggestion by some is to carve it out to create and target a new index. A common argument against using CPI is that food has a high weight of 39.1% in that basket and monetary policy cannot control food inflation. Strange, but a similar argument isn’t heard in other Asian countries, which also have high weight of food in the CPI basket: the Philippines (39%), Indonesia (36.2%), and Thailand (33.5%). Incidentally, all these countries are also inflation targeters.

Instead of justifying India as an exception—it isn’t—we should explore why the countries mentioned above don’t suffer the high volatility in food inflation that plagues India. To be sure, the Philippines, with a weight of food in CPI as high as India’s, has managed to successfully lower its trend inflation. And it isn’t a coincidence that its sustainable growth has also accelerated.

Modi’s economic guides should make a stronger case for the virtuous cycle of low and stable inflation leading to a sustained decline in interest rates. That, in turn, will enhance sustainable growth. Myopia shouldn’t blur the economic and political dividend that can be extracted from this win-win approach.

Rajeev Malik is a senior economist at CLSA, Singapore. These are his personal views.

Comments are welcome at theirview@livemint.com

Close