Do not give up in the battle against inflation
2 min read 11 Mar 2013, 03:21 PM ISTRBI governor D. Subbarao has done well to speak out against those who call for a higher inflation target
Premium(Hemant Mishra/Mint)
Reserve Bank of India (RBI) governor D. Subbarao has done well to dismiss recent calls for the Indian central bank to accept a higher inflation rate.
The debate was kicked off during a seminar held in December at the Indira Gandhi Institute of Development Research in Mumbai, when Subbarao shared the stage with three predecessors—C. Rangarajan, Bimal Jalan and Y.V. Reddy. One of the issues the four central bankers debated that day was whether the inflation target should be raised. That set off subsidiary chatter in the analyst community about a new normal for Indian inflation. Will RBI make its peace with higher inflation?
In a speech (https://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=789) he gave last week, Subbarao clearly explained why RBI does not buy the argument that there is a new normal for inflation, or that he should learn to be less worried about persistently high inflation. The implicit policy implication is that it is still too early to expect substantial interest rate reductions.
The pressure on RBI comes at a time when the global opinion on inflation is changing. International Monetary Fund chief economist Olivier Blanchard has (https://online.wsj.com/article/SB10001424052748704337004575059542325748142.html) hinted that Western economies should target a higher inflation rate. The new government in Japan headed by Shinzo Abe has convinced the Bank of Japan to raise (https://www.japantimes.co.jp/news/2013/01/23/business/boj-agrees-to-uphold-abes-2-inflation-target/#.UT2ax6Dp1mQ) its official inflation target to 2%. There have also been reports asking whether the US Federal Reserve is flirting with higher inflation rates (https://www.reuters.com/article/2012/10/14/us-usa-fed-inflation-idUSBRE89D05420121014).
The debate is a complex one, but there is absolutely no reason to transplant these same inclinations to India. The reason: the underlying economic situation is different. Most rich economies are facing a demand shock and are close to a liquidity trap. Inflation has been very low, and long-term inflation expectations are well anchored. India has had several years of very high inflation. Demand pressures persist. And inflation expectations have been rising.
Subbarao has mentioned six reasons offered by supporters of a new normal for inflation, and clinically demolished each of them. The details can be read here (https://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=789). In effect, RBI governor has pointed out that high inflation is not inevitable in a country such as India. Among other things, he has pointed out that the pressure on food prices is at least partly explained by government “affirmative action programmes, both by way of transfer payments (subsidies) and welfare programmes, which have significantly raised the demand for wage goods while also restraining supply of labour at low wages."
At another level, he has also dismissed the old Phillips Curve argument that central banks can play the growth-inflation trade-off, accepting higher inflation as the inevitable cost of lower unemployment, an argument that was demolished several decades ago by the likes of Edmund Phelps and Milton Friedman.
“Accepting a new normal for inflation not only has no theoretical or empirical support, but entails the moral hazard of policy inaction in dealing with supply constraints. Not a sufficient condition because there is no empirical evidence to establish that the benefits of higher growth outweigh the costs of welfare loss associated with higher inflation," said Subbarao.
Of course, part of the blame for high inflation has to be laid at the door of RBI. That said, Subbarao has done well to say that he does not buy the “new normal" argument.
