Is Raghuram Rajan an inflation hawk?

The answer to that question depends on the rod you use to measure inflation. With the repo rate at 7.5%, is monetary policy tight or loose when compared with the past? Let’s look at history. Since the repo rate has been raised, we should look at periods when the policy rate was going up, rather than when it was going down.

add_main_imageThe last time the repo rate was raised to 7.5% on the way up was in June 2011. Wholesale price inflation in May 2011 was a very high 8.3%. Gross domestic product (GDP) growth during the March 2011 quarter was extremely strong at 9.9%, which came down rather dramatically to 7.5% in the June 2011 quarter.

At present, Wholesale Price Index (WPI) inflation was 6.1% for August 2013, while GDP growth came in at 4.4% for the March quarter. So the repo rate has been raised to 7.5% now in spite of WPI inflation being much lower and GDP growth much slower than was the case in 2011.NextMAds

That suggests Reserve Bank of India (RBI) governor Raghuram Rajan is hawkish on inflation. An additional factor is that this year the central government’s fiscal deficit is expected to be much lower than the 5.75% of GDP reached in 2011-12. Rajan did emphasize repeatedly during his press conference that he didn’t target inflation only, but it’s clear that his tolerance for WPI inflation is much lower and his tolerance for lower growth much more than what used to be the case during the earlier RBI regime.

Let’s take an even earlier period. Before 2011, the last time the repo rate was raised to 7.5% was in January 2007. WPI inflation in December 2006 was 7%, while GDP growth during the December 2006 quarter was 9.4%, down from 9.8% in the previous quarter. Global growth at the time was, of course, vastly different from what it is now. Seen from the perspective of 2007, too, therefore, Rajan comes across as much more hawkish on inflation, at least when WPI inflation is considered.

Does the picture change if we consider the Consumer Price Index (CPI)? Yes, it does, and very much so. We can’t take the new CPI because it was released from January 2011, but in the absence of earlier data, year-on-year comparisons for 2011 are not available. The Consumer Price Index (industrial workers), or CPI-IW, can, therefore, be taken as a proxy for consumer price inflation. The rise in the CPI-IW was 10.85% in July 2013. In May 2011, CPI-IW inflation was much lower, at 8.7%. And in December 2006, it was at 5.6%, but then that was on a different base. The CPI for agricultural labourers, too, was much lower in May 2011 than it was in June 2013. Viewed from the perspective of consumer prices, therefore, Rajan’s stance on inflation doesn’t look very hawkish, compared with previous periods when the repo rate was raised to 7.5%.

That lends further support to the view that RBI is now looking at consumer price inflation, rather than wholesale price inflation, when deciding upon policy. During an interaction with analysts after the monetary policy statement on 20 September, deputy governor Urjit Patel said the central bank looked at multiple indicators, including WPI, CPI and CPI-IW, before arriving at a decision to hike the repo rate.

But there are several reasons why CPI is likely to be the new governor’s favoured measure. The main one is that inflationary expectations are formed on the basis of retail inflation. Also, inflation in the service sector is not covered by WPI. The second clue to his thinking, arising from the first one, is his decision to go in for inflation-linked instruments that are based on CPI. This is a significant structural reform, since it gives an incentive for people to move their savings into financial instruments. It will, in time, lead to higher household financial savings, lower the appetite for gold as an inflation hedge and, hence, put the country’s growth on a more sustainable path.

It has been argued that one big reason for the high consumer price inflation is high food prices and that the central bank can do little to control food inflation. But, as Rajan’s predecessor D. Subbarao often said, if supply-side inflation pressures become persistent and lead to higher inflationary expectations, then the central bank has to act to lower those expectations. Also, it’s not just food prices that have led to a high CPI. While it’s true that core inflation according to WPI has been falling, core inflation (ex-food, ex-fuel) according to the CPI gauge has risen a bit in July and August. sixthMAds

Another way of looking at the question of whether monetary policy is too restrictive is to compare Indian real policy rates with those in other countries.

As the chart shows, with the exception of Turkey, we have the most negative real policy rates. Even neighbouring Bangladesh has a positive real policy rate.

CPI, as well as the comparison with international policy rates and, even more importantly, the need for structural reform in monetary policy, suggest higher policy rates in the future.

That does not augur well for a revival in the economy any time soon, although, in the immediate future, there will be some benefit for industry from the reduction in the interest rate on the marginal standing facility, which will lead to lower short-term market rates.