Partha Sen writes: The Inflation Tightrope
The Indian economy has recently been hit by inflationary shocks. The Reserve Bank of India’s inflation target is 4%, with a 2% margin on either side. However, the RBI has done little to try to reduce the inflation rate given that it has been at or above the upper threshold of 6% since the beginning of this year. Only after inflation hit 7% did it raise the repo rate. So how will this episode unfold?
The fact that part of the inflation comes from abroad is an additional complication. There has also been a steady outflow of foreign funds from the stock market. This could lead to a depreciation of the rupee, which would increase the prices of imported goods (eg petroleum products), thus adding to the inflationary woes. The RBI has raised the cost of borrowing (by 90 basis points so far), with a promise of more to come. The central government eagerly reduced fuel taxes and banned the export of certain items. Instinctive reaction galore. But do our policy makers have enough arrows in their quivers?
Supply shocks are a problem for the authorities. If production is stabilized using macroeconomic policies, prices will rise even more. On the other hand, if they stabilize prices, output (and employment) will fall. Mainstream economists argue that discretion in policy-making is used by politicians for narrow partisan ends. Inflation targeting is rule-based. Monetary authorities raise interest rates if inflation is above the prime target, and vice versa. In fact, interest rates are expected to rise more than inflation, so “real” interest rates rise, causing demand to compress (and economic activity to fall), which in turn turn will reduce inflation. The RBI embraced this idea. In 2016, an independent monetary policy committee was set up. Until recently, the inflation rate was well within its target range, but with supply-side shocks (mainly from food and oil), all hell broke loose. I have the impression that in an effort to follow international best practices, the RBI seems to have fallen for a fashionable hook and sinker framework, without thinking about the structure of the Indian economy. I want to emphasize two points.
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The first point concerns the role of agriculture in the Indian economy. The non-food and non-oil components of India’s consumer price index account for about 47%. In comparison, for the ECB, it is less than a third of the CPI. Of course, the RBI has no control over international food and oil prices, so it must squeeze less than 50% of the national economy to reduce inflation. As mentioned earlier, the rise in real interest rates requires the compression of demand. But the problem is on the supply side. Also, relative to the RBI, the ECB would experience a smaller rise in inflation and has a wider menu on which to apply demand compression.
The second point is the silence on the exchange rate and its effects on production. Until the 1970s, the received idea was that an economy had to achieve both internal and external equilibrium. The first was full employment and low inflation through monetary and fiscal policies. This last objective required a balanced current account over a certain horizon (“not getting too much debt abroad”), using for example the exchange rate. Over time, internal balance has come to mean, from a political point of view, low inflation, since “the market” will ensure full employment (put on the back burner during the global financial crisis and the coronavirus epidemic). Covid-19). For the OECD countries, the external balance was no longer a constraint, since they had made their currencies fully convertible, and international capital flows were no longer restricted.
But is this true for India? If this were so, no one would be interested in discussing the country’s foreign exchange reserves, as these could be generated instantly by exchanging the national currency for foreign currency. Until 2020, India had experienced massive portfolio capital inflows (when OECD interest rates were low) and its current account deficits were financed by foreign exchange reserves. But portfolio inflows can and do reverse. In about six months, foreign exchange reserves have gone from about $640 billion to about $600 billion. FII inflows also contribute to India’s lack of competitiveness. The RBI bought foreign exchange (with rupees). But fearing it would fuel inflation, he sold government bonds and removed excess cash. This “sterilized intervention” led to an increase in the RBI’s foreign currency holdings, accompanied by a reduction in the holding of government bonds. So India’s foreign exchange reserves were not its own—there were liabilities against it. This is different from foreign exchange reserves accumulated through the management of current account surpluses (eg China). The FII rush to India has created “foreign exchange market pressure”. The RBI could have allowed the rupee to appreciate or have accumulated foreign exchange reserves. He chose an intermediate solution – a mixture of appreciation and accumulation of reservations. The appreciation caused by inflows has reduced the international competitiveness of Indian products. Indeed, we had our own episode of the “Dutch disease”.
Let’s go back to inflation targeting. As the RBI raises interest rates, capital outflows may slow as the rupee appreciates. It is not good for the external balance. It is easy to see that inflation targeting could be at odds with the external balance. Our trade minister reportedly said that India is a current account deficit country and therefore depreciation is bad because it makes imports more expensive. Words fail me here. If inflation proves to be stubborn, and the fight against inflation is the only concern of the Indian authorities, we could witness an external crisis. Sounds overkill?
The author is the former Director and Professor of Economics at Delhi School of Economics