Home / Opinion / Price stability should be RBI’s guide

It is no secret that India’s economy suffers from in-built inflationary pressures. Since the global financial turmoil of 2008, the economy has grappled with high and persistent inflation. The high current account deficit, weak currency, low growth, falling savings rate, etc. are manifestations of this disease. The cure is not a quarter of a percentage point increase in the policy rate. The economy has to undergo chemotherapy: painful in the short run yet beneficial in the long run.

What explains the current bout of inflation? Since the financial crisis of 2008, trend growth rate of output has plummeted. To prop up the faltering economy, both the government and the Reserve Bank of India (RBI) pursued highly expansionary policies. As a result, the gap between the actual growth rate of output and its trend growth rate (output growth gap) remained consistently positive. Indeed, standard time series techniques (such as, Beveridge-Nelson Decomposition or Blanchard-Quah Structural vector autoregression) applied to Indian data confirms this (our estimates of the trend growth rate of output is as low as 4.5% today contrary to general belief of around 7-7.5%).

If the actual growth rate of an economy is above its potential growth rate, inflation is bound to raise its ugly head. This is what economic theory teaches us.

Professional economists and pundits who blame poor harvests, price of oil, rupee depreciation, rainfall and everything under the sun for our current predicament are playing a dangerous and dishonest game. None of these causes can explain inflation consistently over time or across countries. Professional economists and commentators require most severe censuring if they back such nonsense. It is dangerous because politicians and the general public, who are not trained in economics, rely on these professionals for expert guidance. It is dishonest because the weight of evidence suggests that they are wrong is before their very eyes.

The key problem is the lack of long-term credibility in counter-inflationary policy. If RBI had been constitutionally independent or even fiercely committed to price stability in practice, with a high profile governor with respect for monetary probity, matters could have been very different. However, until now, RBI commanded no such position; formally an executive arm of the Union finance ministry, it was staffed by people whose knowledge and understanding has not kept pace with recent developments in theoretical and empirical macroeconomics. It has continued to pursue policies which would broadly be described as Keynesian in their orientation and philosophy.

The time has come to reject Keynesian demand management policies and consider urgently alternatives that offer the best hope for sustained growth and low inflation. In this regard, the experience of the Paul Volcker regime in the US in the early 1980s is full of lessons about our own, less drastic predicament with inflation. The aggressive funds rate actions by the US Federal Reserve beginning in October 1979 brought inflation down from almost 10% in 1981-82 to about 4% in 1983-84. All this was achieved in spite of the Ronald Reagan administration allowing the budget deficit to rise far beyond its wildest early projections. Deficits, if projected forward, might have been seen to imply the need for further monetization of the debt to maintain fiscal solvency. The deficits put the Volcker Fed in a familiar bind. In the past, it was understood that the Fed would accommodate rather than resist an expansionary fiscal policy designed to stimulate growth. This time, however, the Fed did not back off.

In 1980, Volcker explained: “In the past, at critical junctures for economic stabilization policy, we have usually been more preoccupied with the possibility of near-term weakness in economic activity or other objectives than with the implications of our actions for future inflation... The result has been our now chronic inflationary problem... The broad objective of policy must be to break that ominous pattern... Success will require that policy be consistently and persistently oriented to that end. Vacillation and procrastination, out of fears of recession or otherwise, would run grave risks."

While challenging the Reagan administration to undertake reforms in order to make the transition to low inflation as painless as possible, the Fed was willing to fight inflation by itself if necessary. The Fed, faced with a high deficit, decided to maintain high real interest rates, in order to gain counter-inflationary credibility. But this proved costly. During this period, the US experienced two recessions generally attributed to tight monetary policy. Nevertheless, this approach to policy was unequivocally vindicated by events. It was a significant tipping point both in terms of breaking the inflationary psychology and in economic performance.

To carry out this reversal of inflationary process, to break the inflation psychology, political courage and determination of a high order are necessary because of the short-term pressures that are generated by vested interests. Such a policy will temporarily curtail growth already underway in India.

Yet the control of inflation has to be given precedence, doggedly maintained and dogmatically asserted, that this policy alone would be able to create the conditions for future growth and prosperity.

Naveen Srinivasan is a professor of economics at the Indira Gandhi Institute of Development Research, Mumbai. Comments are welcome at

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