Shankar Acharya:Inflation and monetary policy

A PIECE OF MY MIND

After several years, inflation has again reared its ugly head in India. In the last four months the annual rate of inflation (as measured by the wholesale price index or WPI) has risen from 4.5 per cent in April to 8.1 per cent in August.

In response the government has taken a number of steps including reductions in import duties on oil and steel products, commodities in which price increases have been sharpest.

A fortnight ago the Reserve Bank moved (some would say, at last) to announce an increase in the cash reserve ratio (CRR) by half a per cent to 5 per cent. There are many issues.

The question I want to focus on here is the role of monetary policy in dealing with inflation. What can we learn from our past experience? Has lax monetary policy been a significant factor behind price increases? Looking ahead, has the RBI done enough to damp the present surge in prices?

First, let's quickly review the basic facts of inflation in India. The upper panel of the chart shows the profile of annual inflation over the last 20 years according to three separate indices: the WPI, the CPI (for industrial workers), and the WPI for manufactures, which account for over 60 per cent weight in the overall WPI.

One reason for separately tracking this last index is that it is a crude proxy for "core" or "underlying" inflation, which abstracts from the volatility in primary product prices and fuel prices.

A glance at the chart reveals some brute facts. First, according to all the three indices, inflation averaged in the band 6"�8 per cent in the second half of the 1980s.

Second, inflation hit double digits during the economic crisis of 1990"�92, as a result of drought, decline in industrial production and a severe import squeeze.

As the economy recovered from these supply shocks and reforms kicked in, inflation moderated to around 8 per cent in 1993-94. Third, there was a rebound to double digits in 1994-95, largely because of the foreign capital surge of 1994, which resulted from the reform-induced turnaround in external sector finances.

This temporary capital surge fuelled money supply growth in excess of 20 per cent. As the forex surge levelled off, so did monetary growth and inflation, though the CPI rate subsided more slowly.

Fourth, after 1996, inflation (according to all indices) hovered around a 4 per cent annual rate until 2003, except for a sharp spike in the CPI in 1998-99 (the short-lived "onion-potato inflation") and a milder uptick in the WPI in 2000-01 because of a weak monsoon and fuel price increases. It is noteworthy that "core inflation" was mostly below 4 per cent until the uptick in 2003-4.

The lower panel of the chart shows recent trends in the WPI and CPI. It shows cycles around a mildly rising trend, with an upswing in WPI inflation after April 2004, one not yet reflected in the CPI.

How did monetary policy contend with earlier bouts of inflation? It played a limited role in the stabilisation programme of 1991-92; devaluation, fiscal consolidation, and structural reforms took the front seats.

Monetary policy was much more active during 1993"�95, when foreign exchange reserves were surging, industry was booming, and inflation was rebounding. Policy had to contend with the competing pulls of accelerating industrial growth and resurgent inflation.

The CRR was hiked by 1 percentage point in summer 1994 and the RBI continued with substantial sales of government securities to partially sterilise the reserve accretions.

But the monetary brakes were insufficient to keep inflation from hitting 12 per cent in 1994-95, although it subsided quickly thereafter to an annual rate (point-to-point) of 8 per cent by June 1995 and below 5 per cent by March 1996.

On the other hand, the economy grew at above 7 per cent for three successive years (1994"�97) and industry at double-digit rates. Arguably, stronger monetary curbs may have speeded reduction in inflation but at the cost of slower growth.

Although temporary monetary squeezes were an integral part of the arsenal deployed successfully to combat contagion effects of the East Asian financial crisis and the Russian debt default in 1997-98, inflation was not a problem.

Not at least till the summer of 1998, when prices of onions and potatoes sky-rocketed by over 300 per cent! By November 1998, the CPI annual rate of inflation exceeded 20 per cent and its food component over 25 per cent.

Despite extreme political discomfort from these massive price increases and pressure to undertake corrective action, the RBI (and government) correctly diagnosed the supply shock-driven price rise as temporary and largely self-correcting. Accordingly, it refrained from monetary tightening in an environment of slack investment and industrial production.

A similar tactic was followed when crude prices tripled from $10 per barrel at the beginning of 1999 to over $30 in late 2000. In the space of one year, the BJP-centred coalition government(s) increased POL prices in October 1999, March 2000, and September 2000, including increases in kerosene on two occasions.

Interestingly, aided by moderate money supply growth in 1999-2000 and 2000-01, these commodity price increases did not lead to any lasting increase in the CPI or core inflation and only a mild and temporary rise in WPI inflation in 2000-01.

The implicit lesson appeared to be that sizable commodity price shocks could be absorbed without generalised inflation, provided monetary conditions were not too lax.

After 2000-01, the main threat to low inflation has come from the massive surge in forex reserves, which rose by $70 billion in three short years.

Despite the loose fiscal policy of the government, the RBI coped admirably with this unprecedented reserves build-up by undertaking large and sustained sales of government securities to offset (sterilise) the foreign assets build-up.

Monetary growth was contained (without sharp increases in real interest rates) and inflation remained low, helped by the combination of low world inflation and a sustained trend of trade liberalisation by India. Inflation control was certainly helped by slack industrial demand for bank credit and the seemingly insatiable appetite of banks for government paper ("lazy banking").

So what lessons can we draw for this capsule review? First, monetary policy may not always be the magic bullet to slay the inflation dragon. Second, nevertheless, monetary policy matters.

Third, supply price shocks need not result in general inflation provided monetary and fiscal policies are not overly accommodating. Fourth, monetary damping of inflationary fires is easier when the private sector is not booming.

Returning to the present and with the benefit of 20/20 hindsight, there does seem to be a case for the RBI to have signalled a mild tightening of monetary policy a few months earlier than it has chosen to do, given the uptrend in both the WPI and core inflation in 2003-04 and the reversal of monetary policy stance in most major industrial economies some months ago. Still, better a little late than never (and realistically, six months ago was election season, when the central bank had to tread carefully).

What is perhaps more intriguing are recent official statements promising no upward change in interest rates. How can modern monetary policy operate on the quantity of money without affecting its price? Or is the recent CRR change purely cosmetic?

(The author is Member, 12th Finance Commission and a Professor at ICRIER. The views expressed are strictly personal)