What is the Reserve Bank of India’s (RBI’s) view of the Indian economy’s prospects over the next 18 months? Does this view justify the RBI’s move to more aggressive monetary policy actions announced on May 3? These are questions TN Ninan rightly raised in his column titled “The wrong war?” on May 7. These are also questions that are directly, if not wholly, addressed convincingly in the monetary policy statement issued in the name of the RBI governor that day.
The early summer statement of monetary policy is by convention the most authoritative articulation of the RBI’s goals and stance. It is based on data for the previous fiscal year, and takes into account the Union government’s fiscal stance indicated in the Budget. The primacy of this statement dates back to a more sedate era when domestic influences were paramount, and it was still possible to speak of a policy for the “busy” and the “lean” season. I am not aware that any of the other major central banks follows an equivalent ritual in the more globalised and fast-paced environment for monetary management today. Nonetheless, I think this practice is worth preserving to provide an accountability benchmark for the year as a whole.
The governor’s case is most compactly enunciated in the introduction. He admits that the resurgence of inflation in the last quarter of 2010-11 came as an unpleasant shock. While asserting that the initial trigger came from abroad, in the form of a surge in commodity prices, he argues that “the fact that these were quickly passing through into the entire range of domestic manufactured goods indicated that domestic pricing power is significant. In other words, demand has been strong enough to allow significant pass-through of input price increases. Significantly, this is happening even as there are visible signs of moderating growth, particularly in capital goods production and investment spending, suggesting that cumulative monetary actions are beginning to have an impact on demand”.
What is one to make of this remarkable formulation? Taken at face value, it seems to assert that pricing power in domestic non-food manufacturing has increased rather than decreased in a slowing economy. A more charitable interpretation would disassociate the recent commodity price spike (mainly in fuels and metals) from pricing power in manufacturing, but this would then raise the uncomfortable question of why this pricing power has surfaced now when it was largely dormant in the golden growth years up to 2008.
In making the case for monetary tightening, the statement cites three proximate factors. These are the outlook for global commodity prices, the overshooting of inflation in recent months, and the fiscal outlook on a business-as-usual, no-reform scenario. These “momentum” factors are only partially offset by the already perceptible slowing of the economy.
The summary judgement is: “Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run [sic], should take precedence.” Press reports about reactions from the finance minister, the deputy chairman of the Planning Commission, the chairman of the Economic Advisory Council to the Prime Minister and the chief economic advisor suggest that the decision to sacrifice growth at the altar of inflation control enjoys at least a modicum of support throughout the government, no matter how slender the analytic basis.
To its credit, the RBI has this time committed itself to a more specific view on the outlook for growth and inflation, with a confidence margin associated with each. In the case of growth, the range of outcomes is projected as lying between 7.4 and 8.5 per cent, with a central level of 8 per cent and the balance of risks on the downside. In the case of inflation, the statement frankly acknowledges the RBI’s poor performance in predicting year-end inflation in 2010-11, at substantial cost to its credibility. The baseline projection for March 2012 is placed at 6 per cent with an upward bias. In addition, in an effort to manage expectations, the RBI warns that “inflation is expected to remain at an elevated level in the first half of the year due to expected pass-through of increase in international petroleum prices to domestic prices, and continued pass-through of high input prices into manufactured products”.
It is instructive to link this discussion to controversies on the appropriate framework for monetary management raging elsewhere in the world. Neither of these is particularly novel, but both are relevant to the situation facing India at this time. The first is the familiar debate on rules versus discretion in the conduct of monetary policy; the second is the suitability of a formal inflation target in the Indian environment, something that the RBI has consistently and repeatedly rejected.
It should be stressed that these are quite distinct debates, in that the implementation of an inflation-targeting regime actually requires entrusting the central bank with almost total discretion in the tools it deploys to hit its target. As against this, the rules versus discretion debate essentially revolves around the near impossibility of timing monetary policy actions correctly so that they act as a force for stability rather than instability.
It would be irresponsible to ask the RBI to commit itself to a formal inflation-targeting regime under the fiscal and debt circumstances that currently prevail in India. However, this does not prevent it from giving primacy to what the Raghuram Rajan report called a “low inflation objective”. Indeed, the record of non-intervention in the foreign exchanges under the present team in the RBI, coupled with the finance ministry’s continued maturity on the issue of capital flows, suggests the RBI is now focused on delivering low and stable inflation. It has now publicised the indicator, namely the wholesale price index for non-food manufacturing, which it intends to monitor as an indicator of demand pressure in the economy. And finally we have “fan charts” for growth and inflation, as well as a clean-up of the system of policy rates.
So at the end of the day, despite my initial concerns, I come away with the feeling that the RBI is moving in the right direction in terms of how it should be held accountable. It is now up to the rest of the research community to give it the tools it requires to do its job.
The author is the Country Advisor, International Growth Centre and Member, Prime Minister’s Economic Advisory Council
The views expressed are personal
