Kaushik Das: The real truth about inflation

It is money supply that is influencing inflation more than oil price hikes

The debate on inflation has intensified more than ever with the Reserve Bank of India's (RBI's) warning note on rising inflation in its Annual Report, 2003-04.

There is a clear difference of opinion among policy-makers over what the RBI should do to control this beast: some favour active monetary tightening, others feel that the best response is not to intervene on the monetary front since raising interest rates will choke last year's stupendous growth rates.

The present rate hike of 0.5 per cent in the cash reserve ratio (CRR) clearly indicates that the RBI favours a tightening on the monetary front.

Economists who favour a tightening of monetary policy strongly believe that the RBI's primary goal is price stabilisation. They support the economic "theories" that justify fine-tuning money supply to avoid price inflation or deflation.

But those who favour non-intervention on the monetary front reason that since the current inflationary trend is of a "cost push" nature, raising interest rates will lead to supply bottlenecks that will be disastrous for growth.

Both arguments are based on a faulty understanding of how inflation is caused. The simple truth is that inflation is always and everywhere a monetary phenomenon. Any increase (decrease) in the money supply by the central bank in excess of actual savings in the economy will eventually lead to inflation (deflation).

It is, therefore, not surprising to see that the countries with the most loose monetary policies are precisely those that experience high inflation.

But what about the oil price hike? Isn't that why India is suffering from inflation? No. Inflation is defined as a continuous rise in the general price level; therefore, a one-time random shock (shortage in oil supply or drought) that causes overall prices to rise is not inflation simply because this increase in the overall price level is a transitory deviation from the trend rate and persists only until the economy adjusts to the shock. Once the economy has adjusted to the random shock, the rate of price rise falls in line with the trend rate.

The monetary dynamics "" that is, the transmission mechanism linking money to prices "" works as follows: Money supply increases by the central bank in excess of the actual savings in the economy leads to temporal misallocation of resources between long-term investments (production goods) and short-term investments (consumer goods). The excess money supply does not reach all the people at the same time.

The cheap money policy works through a temporal sequence to exert an upward rise in the general price level. Therefore, the early round of recipients of the additional money supply will be net gainers (though temporarily) while the later round of recipients will be net losers.

In effect, the excess liquidity in the system causes a temporary unsustainable boom, followed closely by a general increase in price levels for both consumer and producer goods. This false "feel-good factor" cannot last.

The only way to avoid the bust is to stimulate larger and larger doses of money into the system to sustain the artificial boom. The longer and larger the extent of this artificial stimulation, the longer and more severe will be the period of recession or correction that will follow.

Once the true nature of inflation is understood, it becomes clear that the central bank is the culprit. The central bank seldom works independently of the incumbent political party.

Therefore, the last year saw a burgeoning of excess liquidity in the system, as it was the NDA government's way of fooling the people into believing that India was "shining".

The RBI's Annual Report discloses that reserve money increased at a record rate of 18.3 per cent in 2003-04, the highest since 1994-95 (mainly due to its own intervention to prevent the rupee from appreciating to "protect" exporters). The expansion in broad money, too, was the highest since the late 1990s.

In fact, both the prime minister and the finance minister have attributed inflation partly to the "overhang of the excess money supply and liquidity" during the previous regime. The finance minister said money supply shot up from 14 to 16.6 per cent before April this year and up to March 31, but the previous government made little attempt to suck out excess liquidity of Rs 60,000 crore from the system.

Earlier, just before the elections, I had written that India is experiencing an artificial boom because the high growth achieved is by means of monetary manipulation. I had also predicted that this unsustainable growth will be followed by inflation and, eventually, rising interest rates to control the politically unpopular inflation. And this will inevitably result in low growth rates in the next couple of years.

So what are the lessons for policymakers? Stop tampering with monetary policy to keep the failed illusion of "price stabilisation" alive.

Money's impact on the market is always non-neutral and, therefore, any changes in the money supply in an attempt to maintain a "stable" price level will itself be a destabilising force in the economy. The cycles of boom and bust are political in nature "" "political business cycles" "" and their only cause is political control over money supply.