At the moment almost everything that ails the economy, including inflation, is related to supply-side distortions introduced or worsened by the previous government. By raising rates, RBI was only responding to the economic reality created by government initiatives so poorly designed that they managed to hurt growth and increase inflation simultaneously. In essence, RBI was faced with choosing between controlling inflation, or promoting growth and risking further inflation. Given that RBI's primary monetary policy aim is to maintain the value of the currency, it had no choice but to weigh in to control inflation. This impacted growth as well and resulted in the impression that controlling inflation and supporting growth are opposing goals from a monetary policy perspective. This is a false dilemma.
Evidence from across the world indicates that low inflation and high growth aren't mutually exclusive. In India as well, evidence exists that robust, sustainable growth needs low, stable inflation. But in assigning the responsibility of managing inflation, clarity on its various causes is essential.
When Milton Friedman pithily commented that inflation was always a monetary phenomenon, he merely gave voice to the theoretical possibility that monetary policy has the necessary tools to target a desired level of inflation at any point of time. However, this theoretical possibility comes with many assumptions, most of which do not hold true in the real world. In reality, especially in circumstances in which fiscal and regulatory policies constrain the supply side artificially, there are practical limits to what monetary policy can achieve. In such an environment, inflation is almost completely caused by supply disruptions rather than demand overruns, and the role of monetary policy in forcing demand to adjust to reduced supply is restricted by the incremental impact of monetary policy on supply. For example, if supply-side factors cause inflation to rise, interest rates can only be raised till such time that the higher cost of capital does not cause further supply-side constraints. If the higher cost of capital begins to make businesses unviable, further supply constraints emerge, for which there is no monetary cure. In this situation, the only cure is to address the supply-side problems that caused inflation to rise in the first place. This is where India finds itself today.
If the primary supply disruptions are addressed, however, the probability of a sharp fall in inflation is extremely high. At the same time, undertaking the fiscal and regulatory changes necessary to achieve this can be immensely challenging, especially when these changes seek to unwind initiatives that are considered popular or populist. Fortunately, not all the supply constraints in the economy today are caused by populist policies. Some, such as coal and power supply, are bereft of any political colour and can be rectified without losing popularity or incurring significant fiscal costs. These need to be addressed on a war footing. Others such as the creation of infrastructure assets do have a fiscal cost, which we may ignore if they result in increased economic productivity. Still, others such as agricultural supply are politically sensitive, but well-designed solutions that reduce the gap between farm and store prices have the potential to provide adequate political cover. In addition, revenue- and outcome-neutral measures such as reduced taxes on oil products to set off a discontinuation of subsidies can be undertaken to streamline government intervention and costs. This will allow the private sector to participate in oil retailing, opening the field to competition and further efficiencies.
If the government chooses to face these problems head on, inflationary impulses resulting from these constraints will shrink and inflation will soften. Falling inflation will encourage RBI to ease the supply of capital as well. If the resultant increase in demand is offset by further supply improvements as business viability and efficiency increases, a virtuous cycle may be initiated and sustained over the medium term. This would provide the political protection needed to unwind the more populist constraints.
When faced with supply-side changes, a central bank is forced into a reactive stance. It does not create the economic environment, but merely responds to it. Just as RBI was responding to the environment when supply-side inflationary impulses were worsening, it will respond when they improve as well. In our specific situation, just as artificial supply constraints increased inflation and hurt growth, their solutions will soften inflation and promote growth. In this environment, it would require exceptional circumstances for RBI to oppose the trend.
As such, rather than support speculation on possible confrontation between the government and RBI, economic circumstances today point to the polar opposite. It is clear that the government, based on its campaign and mandate, needs to take immediate and effective steps to control inflation and promote growth. It is equally clear that the government is in a position to initiate extremely specific measures to that end. It is, therefore, apparent that RBI will find itself in the position of a natural partner, rather than an adversary, to government efforts.
However, this doesn't mean that RBI will open the monetary floodgates. As foreign institutional investors return to India and under pressure to stop the rupee from appreciating sharply, RBI will intervene to buy the dollar. While this will inject significant amounts of rupee liquidity into the system, RBI will make meaningful efforts to sterilise it. This needs to be seen through the lens of monetary management alone and not as a monetary policy stance. The monetary policy stance will respond primarily to government initiatives for managing supply constraints. If inflation falls in response to these initiatives, interest rates will follow. You can count on it.
The writer is Director & Business Head Portfolio Management Services & Product, Pramerica Asset Managers. These views are personal