India: Deciphering and Solving the Inflation Crisis

India has an inflation crisis. From 2006 onwards, the yoy rise in CPI-IW seems to have gone unhinged.  See the following graph:

Why did this happen? We have a `Nobody killed Jessica’ situation here. Sharad Pawar and D. Subbarao both insist that the problem cannot be laid on their doorstep. I would argue that it was the currency policy from 2003 onwards (large purchase of dollars with partial sterilisation) which gave us this mess, which was then compounded by repeated RBI speeches saying that inflation is not important, and RBI actions which were soft on inflation.

The weakness of macroeconomic thinking in official circles is visible, with government actions including banning exports, sending the police to raid traders and hoarders, etc. I believe there is an iron law of economic policy: across each doubling of GDP, you have to reinvent government. The trouble in India is that we are getting each doubling of GDP in a decade or less, giving a very large gap between the structures of government and the underlying conceptual frameworks, when compared with the requirements of the economy. With agriculture at only 15% of GDP, one has to think differently about the role of food in inflation as a macroeconomic phenomenon.

Getting back to stable 4% inflation is terribly important, and it’s going to be hard. In recent weeks, Ila Patnaik,  a senior fellow at the National Institute of Public Finance and Policy in New Delhi, has written four newspaper pieces which add up to an interesting perspective on inflation: 20 Dec, 25 Dec, 3 Jan, 13 Jan. And my article on food price volatility may also be useful.

Patnaik has argued that the actions of the RBI have sent a signal that they are very comfortable with current inflation and growth levels.  He has also argued that the RBI has had no real choice but to increase liquidity because of illiquid private money markets and that this has been a key element in raising inflation expectations.

In his third article, Patnaik implies that political pressure has brought forces to bear against raising interest rates.  He wrote:

The performance of the Indian economy in 2010 was beyond expectations. GDP growth was higher than expected. But at same time, inflation was also above acceptable levels. The current account deficit was higher than historical levels. Property prices rose at an average of 30 percent during the year. Liquidity became tight and credit demand rose. By the end of the year the Indian economy witnessed most signs of overheating.

However, concerns about output and employment growth weighed upon policy makers. There was no serious attempt at fiscal consolidation. Monetary tightening neither pulled output growth down, nor contained inflation. Did India err on the side of too much caution? Should macroeconomic policy have been tightened much more to prevent overheating?

Macroeconomic policy making is hard as involves judgement and is done under conditions of uncertainty. Raising rates is also almost always harder than cutting them. Few people criticised Greenspan’s low interest rates or clamoured for hikes in the Greenspan years. The great moderation with low inflation and stable growth was appreciated by most at the time.

India is one of the fastest growing economies in world today. It is an engine of growth for the world economy. High growth rates in India are above expectations and almost unbelievable. A rate hike that would upset growth would be unpopular.

On 13 January Patnaik focused on the food inflation problem, among other areas.  He says the likely action by policy makers will involve “sighing with relief” when agricultural prices come down again after no meaningful policy changes get implemented.  He also criticizes the lack of any stabilizing macroeconomic policy – that there has been no adjustment of stimulus after the need has subsided.  He expands on that with a discussion of the lack of identifying when and how contractionary monetary policy should be used.  His conclusion:

No one step will be able to bring inflation under control. The government must adopt a multi-pronged strategy to inflation. Agricultural reform must go hand in hand with contractionary fiscal and monetary policy.

 Editor’s note:  Sunil Chandra discussed RBI policy issues in a GEI Analysis article posted on December 27, 2010.

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Will India GDP grow by more than 10% this Financial Year? by Sanjeev Kulkarni

2 replies on “India: Deciphering and Solving the Inflation Crisis”

  1. I think a very valid point regarding currency policy and misplaced priorities – inflation should always be a worry with a central bank. However, I think the problems are more deeply entrenched and complex.

    I think it is not the case either that – a)RBI purchased currency or b)RBI forgot to sterilize. Answering the second question first – RBI did not sterilize simply because it could not sterilize. Looking at the balance sheet of RBI, one sees that in mid 90s, its assets primarily comprised of govt securities. However, by early ’00s, the assets were mostly forex. I believe that the sterilizing in late 90s led to a situation where no more sterilization was possible. Regarding currency purchase – I think the rupee was devalued and capital flowed into India; RBI not actively buying forex, but rather forced to buy it to keep the rupee at what it thought was the ‘correct’ level.

    Of course, the other set of causes are fiscal – with the fiscal deficit increasing significant in the mid and late ’00s. Tax cuts and low interest rate regime served to stimulate consumption, and later commodity purchase (gold, real estate) at the expense of investment.

    However, I dont agree that policy makers will just “sigh with relief” – I dont think there will relief. Inflation was bound to occur because of the monetary situation and I think the food shortage just served to ignite the process. I think the ideal solution would require decreasing the fiscal deficit, raising interest rates AND allowing the currency to appreciate – classic contractionary policies and together likely to result in a recession. However, delay in implementing these would only worsen the recession when it occurs. In effect, I believe that India should NOT aim to grow at above 7% p.a., and maybe even sustained 7% is high.

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