A V Rajwade: NAIRU and NAIRG

WORLD MONEY

Has the central bank found a NAIRG "" a non-accelerating inflation rate of (GDP and credit) growth?

NAIRU is the "non-accelerating inflation rate of unemployment". The acronym was much used in the obituaries of Milton Friedman a few weeks ago. While placing money supply and price stability at the heart of economic policy, Friedman had argued that inflation does not reduce unemployment as, with a lag, the economy re-adjusts to its earlier level of activity, except at higher prices. A corollary was that any effort to bring unemployment below NAIRU would be inflationary. Joseph Stiglitz recently referred to the concept in an article on Edmund Phelps, the 2006 Nobel Laureate, who showed that the relationship between unemployment and inflation is not constant and keeps changing over time. At one time, for the US economy, NAIRU was thought to be 6 to 6.2 per cent "" in fact, unemployment in the US fell well below 6 per cent without kindling inflation. The provocation for remembering NAIRU comes from the Reserve Bank's increase in the cash reserve ratio (CRR), within a few weeks of the reverse repo rate. Has the central bank found a NAIRG "" a non-accelerating inflation rate of (GDP and credit) growth? While most editorials have welcomed the central bank's step, I remain perplexed by both its logic and the instrument used.

As for the logic, year-on-year WPI growth has gone up from 4.1 per cent at the end of March to 5.3 per cent as on November 25. However, there is "a seasonal decline in prices of food articles ... (and) ... the recent reduction in prices of petrol and diesel will moderate inflation" (RBI press note). The last three weeks' actual index numbers are evidencing a fall in prices, even before the moderating factors have kicked in. In fact, the index had been rising at a steady rate this fiscal year, but has fallen below the trend line over the last two months, that is, since before October 31!

Did asset prices trigger the move? When the CRR hike was announced, the Sensex was at an all-time high of 14,000. And, while one does not know whether moderating asset prices (equity and real estate) is one of the objectives of monetary policy, the press note said that "conditions in financial markets continue to be stable and orderly". Clearly, inasmuch as the equity market is an important part of financial markets, there is no reason to suspect that the central bank was worried about equity prices. On the other hand, in the past it has expressed more concerns about the real estate market, and the increasing exposure of the banking system to both housing and commercial real estate. To be sure, real estate prices in places like Mumbai have gone up sharply in the last couple of years. On the other hand, it also needs to be noted that this has occurred after at least four-five years of relative stability, and indeed even a fall. The proposed abolition of the ULCRA in Maharashtra would also improve the supply side at least in Mumbai. (Unfortunately, one does not have any access to a proper real estate price index and has to rely on hearsay.) In any case, if the worry was real estate, surely it would have been better to put a sectoral limit on exposures, rather than using a more blunt instrument like the CRR, which will increase the cost of capital for all "" individuals, the corporate sector and the government?

One wonders whether the real reason was discomfort with the rate of growth in both GDP (9.1 per cent in H1) and bank credit (30 per cent), or frustration that the earlier move (the hike in the reverse repo rate on October 31) did not get transmitted in market rates. As for the first, the prime minister seems to be aiming at a 9 per cent GDP growth and it is difficult to see how it can be achieved without a much larger than 20 per cent growth in bank credit. It should also be noted that, as the fiscal deficit comes down, more investment will shift to the private sector and the credit portfolio will have to compensate for the relatively lower growth in holdings of zero risk government securities, if investment and growth are not to fall. If the central bank finds it difficult to accommodate credit growth on the needed scale, despite our monetary aggregates as a percentage of GDP being well below the Asian average, consistent 9 per cent growth will remain a dream. To quote from Stiglitz's article, "inflation, should it increase slightly, (can) be reversed at a relatively minor cost "" comparable to the benefits of additional employment and growth enjoyed in the excessive expansion of the economy that led to the increase in inflation."

As for the instrument used, in a discussion with senior policymakers in the RBI at the time of introduction of the market stabilisation scheme, I had argued that it would be better to use CRR rather than introduce MSS. Wiser counsels obviously prevailed. But, in that case, why the reversion to the CRR as an instrument of monetary policy?

avrajwade@gmail.com