The International Monetary Fund [IMF] has released a staff paper on “Monetary policy transmission in developing countries – evidence from India” which concludes that the co-relation between monetary policy changes and aggregate demand [which has a direct bearing on inflation] in developing countries like India is weak.
The revelation has come at a time when the government has amended the RBI Act [June 27, 2016] to set up a Monetary Policy Committee [MPC] and is now in the process of constituting it [it will have 3 nominees from GOI and 3 from RBI including the governor who will also be its chairperson]. The union cabinet has also fixed the inflation target at 4% [+/- 2%] for a 5 years [2016-2021].
The MPC will keep an eye on the inflation rate as measured by changes in consumer price index [CPI] on a month-to-month basis. In case, CPI exceeds 6% or falls short of 2% for three consecutive months, it will send a report giving reasons for deviations. It will also suggest remedial measures, mechanisms for their implementation and time frame over which the inflation is brought back within the specified range .
Among the measures, the committee will remain focused mostly on adjustment in the interest rate [or ‘policy rate’ at which apex bank lends money to banks] and other policy instruments such as cash reserve ratio [CRR] [percentage of deposits that banks have to keep with RBI] to rein in inflation. MPC will swing in to action from October 4, 2016 when the next policy review is due.
It would be worth putting in so much of effort and resources only if, the policy instruments that RBI has in its armory can make any meaningful impact on inflation. But, if the inherent link between the two is itself weak – as alluded to by IMF staff paper – it won’t make any sense to run through this mammoth exercise.
The need for introspection is even greater as unlike in the past when ‘inflation targeting’ by the apex bank was more in the nature of a self-goal set by the governor [it went more by the person occupying the chair; to pursue or not was entirely his prerogative], now this has been institutionalized. The MPC has no option but to pursue as it is mandated by the law.
What is the reasoning advanced by IMF? It argues that in developing countries a lot many things happen ‘outside’ the formal sector whereas, any policy decision that the apex bank takes has an impact only on the formal sector. To better understand the implications in Indian context, let us look at the factors that impinge on inflation.
Nearly 50% of CPI includes food items. Most of these are susceptible to changing demand-supply balance. For any given level of demand, a decrease in supply can lead to consumers having to pay more. If, there is a shortage of say pulses or vegetables, their prices will tend to shoot up. But, how does credit enter the scene? Does interest rate play any role in affecting prices?
We need to carefully look at the dynamics on both the demand and supply side. On the demand side, it makes no sense to expect a housewife to buy more and keep these items in stock. But, a more likely scenario is one whereby a wholesaler/intermediary indulges in hoarding to exploit the shortage situation. Where does he get the money for doing this?
It would be naive to contemplate that he will get funding from the banks. While, extending credit, banks are governed by prudential norms and any manager would be violating these at his own risk. Moreover, a vigilant government can always exercise checks and ensure that no bank gets in to giving loans for such despicable activity. However, a more relevant question is whether a wholesaler/intermediary in India really needs any financial support from banks?
The answer is a categorical no as he has plenty of cash, courtesy, abundant stock of currency notes in circulation. Indeed, most of it is black money even as majority of transactions bypass banking channels and on which no tax is paid. There is ample evidence of even politicians [as also bureaucrats] having amassed illegal wealth not just by accepting bribe but also, siphoning off funds from the subsidies meant for poor under welfare schemes. No wonder, many of them either on their own or their relatives are in the business of trading.
So, there is rampant hoarding especially when there is shortage of essential items. The hoarders also take advantage of poor logistics and infrastructure which prevent timely movement of supplies [for instance, thousands of tons imported pulses that union government ordered early this year to cool their prices remained stuck at port]. It is this unique factor that is primarily responsible for inflation in India.
The availability of bank finance neither has a role in it nor, the apex bank can do anything in controlling it. Unless the black money and associated hoarding is reined in, inflation monster will continue to rear its head irrespective of whether RBI follows a tight or accommodating monetary stance, keeping interest rate high or low.
Yet, on a mistaken notion that lower interest rate and more liquidity [vide more credit] would exacerbate inflation, RBI has invariably kept the policy rate high. While, this has done little to rein in inflation [due to lack of any connection], it has unambiguously come in the way of propelling growth by denying credit to critical sectors and increasing cost of production. The proof of pudding is in eating.
During Sept, 2013 to Dec, 2014, Rajan was glued to high policy rate even as Modi – dispensation was creating conditions [expediting approvals, unclogging stuck projects, improving ease of doing business, reforming FDI regime etc] for extricating India from low growth trap. Since January, 2015, he reduced the rate not because he developed any empathy for growth but merely due to fall in CPI. With CPI inching up during May-July, 2016, he has put a stop to rate cut. Thus, in bi-monthly reviews on June 7, 2016, and August, 2016, he kept policy rate unchanged.
Under the MPC dispensation too, in the next policy review on October 4, 2016, any rate reduction is unlikely to happen as the RBI mindset remains stuck in ‘inflation targeting’ groove and has even been legitimized following amendment to the RBI Act. The appointment of Dr Urjit Patel, who is known to be an “inflation warrior” as the new governor has further ruled out such a possibility.
But, the point made in the IMF paper serves a wake up call. The government and RBI should recognize that a multitude of factors impinge on inflation and it would be imprudent to address it only under monetary policy framework. The MPC should take a holistic look at the phenomenon and come up with solutions that bank primarily on macro-economic prudence. Tackling black money and corruption has to be an essential ingredient of this approach.