RBI, gripped by doubts, revisits classic inflation theory

Asking the head of a central bank whether he believes that monetary remedies are the best antidote to inflation is like
asking the Pope whether he believes in Jesus Christ. To both, it is an article of faith and even to raise such a doubt is a blasphemous act.

Asking the head of a central bank whether he believes that monetary remedies are the best antidote to inflation is like
asking the Pope whether he believes in Jesus Christ. To both, it is an article of faith and even to raise such a doubt is a blasphemous act.

Let us begin with the latest.  The headline inflation for June stands at 7.25% and the retail inflation at 10.02%.

With the quarterly review of the monetary policy only days away, this news on the price front must be acutely embarrassing for the Reserve Bank of India (RBI).

Reacting to this news, the governor, Duvvuri Subbarao, appeared flummoxed and conceded that, “even after persistent and prolonged monetary tightening… we have not been able to restrain inflation”, which is still way above the threshold.

According to Milton Friedman, the high priest of monetarism, inflation is taxation without legislation and is “always and everywhere a monetary phenomenon”. Central banks of most countries, though not fully subscribing to this theory, nevertheless set high store by monetary tools like repo rate and cash reserve ratio to ensure price stability, defined as a rate of inflation that is sufficiently low that households and businesses  do not take into account while making everyday decisions. In fact, many central  banks have explicit inflation targets while the RBI sticks to what it calls “indicative” projections.

Yet, from the recent Indian experience, the faith in the ability of the RBI to rein in inflation seems to be waning.  Consider the recent empirical evidence. Between the last week of March 2010 and March 2012 — that is, over the two fiscal years of 2010-11 and 2011-12 — the repo rate has been hiked 10 times or by 350 basis points. In April 2010, the headline inflation was 10.88% and in March 2012, it was 7.69% after scaling a double-digit of 10% in September 2011.

The inference is clear. Despite repeated monetary tightening, the inflation rate is still ruling above the comfort level.  With candour and forthrightness, Subbarao has conceded that, while this dear money policy has hurt growth and investment, battle against inflation has yielded no tangible results. He also added that, while in the short term, there was a trade-off between growth and price stability, in the long term, no such trade-off can be countenanced.

Lending further weight to the limited effectiveness of the monetary policy in combating spiralling prices is a research-based article in the RBI’s Working Paper Series issued less than a month ago.
The piece, Monetary Transmission Mechanism in India: A Quarterly Model, authored by Muneesh Kapur and Harendra Behera, after an exhaustive analysis, comes to the conclusion that,  while the RBI’s monetary policy had a dampening impact on inflation, results indicate that “the impact of monetary tightening on inflation is modest”.

Minimum support prices, oil prices and non-oil prices impact on inflation in varying degrees and with different time lags. Inferentially, there are more causative factors influencing inflation than the monetary stance of the central bank.

Let us now harken back to December 2005 and what that year’s Currency and Finance Report by the RBI — which had carried an elaborate study on monetary policy and inflation — had to say on this very topic. To quote, “it is now widely agreed that monetary policy can contribute to sustained growth by maintaining price stability”.

Attributing the low and stable inflation rates achieved during the eighties and nineties mainly to improvements in the conduct of the monetary policy, it said there is an ongoing debate that other factors like globalisation, deregulation and competition  as well as prudent fiscal policies may also be responsible.

But the thrust of the article in the report is clear, namely, monetary measures were instrumental in ushering in an era of benign inflation rates. Look at what it says further: “Based on the record of past half century, while in the short run, supply shocks can lead to large changes in headline inflation, persistent high inflation is ultimately the outcome of lax monetary policies”.

Less than seven years later, the two authors of the Monetary Transmission Mechanism in the Working Paper Series (June 2012) see this issue through a different prism.

“Despite the monetary tightening by the RBI in 2010 and 2011, inflation remained high and this could be attributed to the structural component of food inflation as well as the surge in international commodity prices….”.

In other words, supply side issues – shortfall in production, snafus in distribution, high cost of imports of items where domestic  output is insufficient and hoarding and black marketing — do impact on the price level.

At best, monetary policy may have a salutary impact on core inflation – that is, price changes in commodities, chiefly manufactures that are free from volatile elements, food and fuel groups. But, if the headline inflation stays at an elevated level over an extended period of time, as is now the case, monetary measures alone may not be enough.

Both the government and the central bank may have to work in tandem to quell the price fever. At home, prudent budgetary policy and growth-promoting strategies can go a long way in lowering the inflation rate.

As Chester Bowles, the famous American politician who had served as ambassador to India, observed, “Production is the only answer to inflation”.

This is the role of government and then monetary policy can play a contributory role. But, as of now, the RBI is left holding the fort while the Centre dithers.

No wonder then that inflation appears to be well entrenched in the economy.