RBI's nuanced approach to inflation
High inflation is being driven by surging global commodity prices
The Reserve Bank of India's annual monetary policy statement in May and its mid-quarter review last week, by many yardsticks, are seen as a break from the past. That only few observers have commented on the new look policy is most certainly due to the fact that the monetary policy, unlike the fiscal policy (the Union budget), hardly evokes the kind of widespread scrutiny or excitement. That remains so despite recent attempts to make the monetary policy more accessible to the common man.
There have been a number of other plus points. The policy statements of the day are substantially free of jargon. This is a stupendous achievement. By their very nature, monetary policy documents deal with subjects that do not lend themselves to easy descriptions or analysis that will be intelligible to the man on the street.
It is perhaps no coincidence that the annual policy is unveiled by the RBI Governor at a meeting of top bankers. The Governor and other senior RBI officials might address the press and face television interviews subsequently but the basic format of the policy — announced before bankers — rather than television cameras remains.
It should not be forgotten that any policy statement that tries to reach out to wider sections is more difficult to be prepared than one which has as its main constituency, bankers and finance experts.
The annual policy statement and the mid-quarter review that followed it fit into the recent mould of policy announcements that strive for transparency and reach out to the common man. One outstanding example is the dissemination of information on what has become one of the core topics in today's public policy discourse, namely, inflation.
It is well known that the recent policies have overwhelmingly come out in favour of containing inflation even if that has come at the expense of growth. Practically all policy statements have discussed this trade off but none could have done better than Governor D. Subbarao. In the annual policy statement he had this to say:
“Before I close I want to reiterate what I had said earlier, by making a brief comment on the growth-inflation trade off, an issue that has been widely debated in the run up to this policy. High and persistent inflation undermines growth by creating uncertainty for investors, and driving up inflation expectations.
“An environment of price stability is a pre-condition for sustaining growth in the medium-term. Reining in inflation should, therefore, take precedence, even if there are some short-term costs by way of lower growth.”
The deleterious consequences of inflation are well known. It will impact adversely on the growth prospects. India's poor with already low living standards will suffer the most. The RBI in its monetary statements has devoted considerable space not just to inflation but also to inflation expectations. The connection between the two has once again been well brought out in the annual policy statement.
High inflation is being driven by global commodity prices which have surged in recent months. There is every possibility that they may increase further even in the short-term. So there is a real possibility of inflation getting even worse.
Even the most pessimistic inflation projections of recent months have been exceeded, there are serious concerns that inflation expectations may become unhinged.
What the central bank is alluding to is the simple fact that rising prices beyond a point feed themselves. For instance, households reeling under high food inflation do not see any respite in the food prices in the year ahead.
In the case of petroleum products, nobody expects their retail prices to come down. Notwithstanding last Friday's steep increase in the retail prices of diesel, kerosene and cooking gas, the betting will be on still higher prices. Not only are global petroleum prices high, but domestic prices have by and large remained cushioned by subsidies by the government and to an extent by the losses borne by the oil marketing companies.
Certain well known public policy instruments are relevant for conditioning inflation and inflation expectations.
The monetary policy should have a clear and stated inflation objective. Second, the central bank must have the appropriate instruments and have the freedom to use them. Finally, there should be an effective transmission of monetary policy.
The RBI has recently taken some bold steps: (a) a 0.75 percentage point increase in the repo rate over two policy statements (in contrast to the small ‘baby' steps of previous policies; (b) making the repo rate the sole policy rate; and (c) the creation of the Marginal Standing Facility from which banks can borrow at the repo rate plus one percentage point.
Not only will the RBI be able to manage liquidity better, but it effectively assumes the traditional role as a lender of last resort. Monetary transmission should improve as a result of these changes.
The fact that the RBI and the government do not, at least publicly, differ in their assessments of growth indicators is another positive factor.
The RBI's recent action in lowering its GDP forecast sharply has probably made such estimates more realistic. Credibility of official data will certainly help in having a better idea of the price situation both at present and in the future.
C. R. L. NARASIMHAN
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