T C A Srinivasa-Raghavan: Music to RBI's ears

OKONOMOS/ Inflation is usually not the central bank's fault

For close to 75 years now, economists have failed to agree on what causes inflation. Some say it is a monetary phenomenon (too much money chasing too few goods) while others say it is caused by sudden increases in costs (oil shocks, droughts and so on).

But they do agree on one thing: inflation is always the central bank's fault. It either does too much, or too little, and always too late.

So as long as inflation was low, as it was during most of the 1990s and through the first three years of this decade, credit was given to supply side factors, notably increases in productivity.

But now that inflation is climbing again, blame is being laid at the doors of the central banks. They have not controlled money supply adequately, is the refrain. India is no exception to this chorus.

The real issue, however, has always been what triggers inflation. A recent paper* by Ilker Domaç of the World Bank and Eray M Yücel of the Central Bank of Turkey throws light on this. Central banks emerge smelling of roses.

Domac and Yücel have investigated 24 inflation episodes in 15 Emerging Market Economies (EMEs) between 1980 and 2001 and what started these off. They claim this is the first time this is being done for emerging market economies.

But to see what triggers inflation, it is necessary first to see why it was stable for so long. Low inflation, say the authors, was caused by a combination of factors in which central banks played only a supporting role.

"Fiscal consolidation was one of the key contributing factors. These were lowered by one-half from the levels that prevailed in the 1970s and 1980s." Then there was the fall in global inflation as well, and, in the first half of the 1990s, the decline in oil prices.

Institutional reforms, such as the enhancement of central bank independence, also helped. So did structural reforms in trade, product and labour markets along with the improved access to global capital markets.

But what sets off inflation then? "An increase in the output gap, that is, above-trend real economic activity, agricultural shocks and expansionary fiscal policy raise the probability of inflation starts in EMEs."

This will come as music to Reserve Bank of India's (RBI's) ears. India has had all three, and that should let the RBI off two of the three hooks.

However, the authors do say that "the link between economic activity above trend and inflation starts in EMEs appears to be quite robust. This suggests that central banks should closely monitor the current and future path of aggregate demand in the economy."

Agricultural shocks have always been important for inflation in the emerging market economies. This is because food accounts for a larger share of the consumption basket and food prices are subject to the vagaries of the weather.

But this "complicates the conduct of monetary policy in these countries is because the role of monetary policy is more lucid and its impact is more potent when inflation is mainly driven by demand shocks and when demand changes can be traced by indicators such as monetary growth or output gap."

The policy lesson is that EMEs should liberalise agriculture to allow imports that will reduce the volatility of food prices. And central banks "should make an effort not to accommodate such shocks as their accommodation can lead to demand-driven inflationary pressures."

This is easier said than done, especially when one finds the authors soon arguing that the "competitiveness of political participation", that is, democracy, helps keep inflation down. This is the old Amartya Sen argument, first made in respect of the deaths in the Chinese famines of the late 1950s.

But it does not take into account the fact that the quest for low inflation also raises the level of subsidies and, therefore, promotes higher revenue and fiscal deficits. It also distorts the price of money, as we are seeing now in respect of agricultural credit.

Ensuring a high quality of external financing is also important. "Countries with less stable external financing encounter difficulties in using the exchange rate to weather external shocks; flexible exchange rate regimes are viable in financially open economies provided external financing is not based on very volatile capital." Again not easy to ensure if you are the central bank.

In India, there is an added complication: price data is collected by government agencies. There is no reason to believe that those engaged in this particular activity are islands of excellence in a sea of government sloth. So the data could be as dodgy as everything else that emanates from the government.

Thus, we know prices are rising. But at what rate, exactly?

*What Triggers Inflation in Emerging Market Economies? World Bank Policy Research Working Paper No. 3376, August 2004