At its monetary policy review earlier today, the RBI announced an interest rate hike in response to persistent inflationary pressures. The repo rate – the rate at which the RBI lends to banks – was increased by 25 basis points (0.25 percentage points) to 6 per cent and the reverse repo rate – the rate at which the RBI withdraws excess liquidity from the system – by 50 basis points to 5 per cent. In five rate hikes since March 2010, the repo rate has gone up by 125 basis points and the reverse repo by 175, making the RBI the most aggressive central bank in the world on inflation in 2010.
Shorn of context, the last statement would strike you as decidedly odd. The RBI isn’t your typical inflation-targeting central bank. In fact, on the evidence of the last two decades, the RBI hasn’t really targeted inflation at all, preferring to target growth instead. An inflation-targeting framework implies the setting of an inflation target or band and assigning responsibility for meeting that target to an independent central bank through the manipulation of its policy rate or reference rate: usually, the rate at which the central bank lends money to other banks.
The inflation targeting framework has become very popular over the last decade with many central banks switching over to it. It is simple, transparent, highly credible and allows the central bank to act independently outside of any political influence. If economic growth is high, one could theoretically rely on an independent central bank to spoil the party by “leaning against the wind” and raising interest rates to reign in the boom. Alternatively, during a recession, the central bank will act to provide a demand-side stimulus to growth by reducing interest rates but would not fall all over itself to respond to the cries of politicians to help create jobs and boost a recovery.
Government’s favourite whipping boy
The RBI, on the other hand, has always had an uneasy relationship with the concept of autonomy. Regularly bullied by the central government on issues from policy rate setting to deputy governor appointments, the RBI has cloaked itself in an opaque policy objective, armed itself with multiple policy instruments and produced fairly unpredictable responses over the years. Alternately saddled with the responsibility to boost growth, reduce inflation (especially before elections), support the currency and so on, the RBI is more like the unofficial fire-fighter of the economy.
So, during the global recession, when the Indian economy ‘slumped’ to 6.7 per cent in 2008, recovering to 7.4 per cent in 2009, the RBI leapt in headfirst to stimulate demand by slashing rates. It was hardly alone in doing so. Where the Indian economy has been alone (even by emerging market standards) is in the violent inflation response that has followed.
Fast and furious: inflation in 2010
The average wholesale price inflation in 2010 has been 10.6 per cent. Year-on-year food price inflation as of August was an astonishing 14.6 per cent, with fuel price inflation at 12.5 per cent. The strong monsoon rains should reduce the pressure on food prices (although last week food price inflation actually rose because heavy rains were disrupting supplies!) but this has only shifted the focus back to non-food price inflation which, at 7.7 per cent is not only uncomfortably high but rising.
In a country where elections are won and lost over the price of onions, high and sustained inflation is political death. Perhaps this explains why India has managed to escape the hyperinflation traps of the toy Latin American democracies of the 70s. I think it a mark of the strength of the UPA government that they have weathered the political storm over inflation in 2010. But with rate hikes taking at least 6-12 months to have any impact on inflation and with key elections next year, the government is running out of time.
And doesn’t the RBI know it, acting as aggressively as it has ever done to try to take control of the situation. It has increased the number of policy reviews and consistently beaten market expectations on the size of the rate hike. Industry is becoming unhappy. Recent GDP figures have been strong, but as I wrote a couple of weeks ago, there are plenty of questions being asked about a potential slowdown in global markets, falling export growth, the fading of the crisis stimulus and weak domestic demand. These concerns, however, have been firmly set aside. The RBI has even shelved its usual attempts to manage exchange rate appreciation. Inflation-fighting is the need of the hour.
A nation turns its lonely eyes to you
Playing Superman isn’t easy and the RBI needs a lot more help than it has been getting from the government. It has rightly pointed out that monetary policy can only manage aggregate demand, whereas rising prices in India are as much a supply-side story. Food prices are ridiculously dependent on rainfall and non-food production is choked by supply constraints such as the lack of infrastructure. The FM must do more than occasionally appeal to Lord Indra for assistance. We’ve seen ambitious plans to reduce agricultural sector vulnerability, reform the PDS and quicken the pace of infrastructure expansion but till we see results, the RBI will only careen from one crime-scene to another instead of independently managing a stable macroeconomy.
Anisha- I am thankful to you for having demystified a lot of things in your post. If my question sounds a bit amateurish the fault is entirely mine.
You say that the looming elections might have something to do with its excessive focus in inflation even at the cost of certain other indicators. I just want to make sure that this accusation is correct.
I understood the first part of your argument to mean that an “inflation targeting central bank” is normally politically independent and the RBI is not politically independent because it does not strictly stick to that role.
But probably this opaqueness of the RBI’s policy objectives and the unpredictable way it responds has something to do with the facts that you highlight- that the problems in India are more supply side driven. In the paper you have hyper linked also it is noted:
“One problem is that no one seems to have a good model of the Indian economy’s responses to supply shocks, monetary policy, or perhaps to anything at all. Policy making is mostly ad hoc. So there’s potentially plenty of work for economists in India, or those studying India.”
So probably, this is the reason for the opaqueness of RBI policy and why it just cannot stick to the role of an inflation targeting central bank – not because it is mindful of the elections. Is this correct?
Hi Subramanian, and thanks for your comment. One of the problems with writing in such a short format is that you end up making a lot of points in very few sentences without justifying much of what you’ve said. I apologise for rushing the arguments along.
The first point you’ve raised is about central bank independence. Let me explain what I mean when I talk about political influence on the working of a central bank. Central banks are inherently conservative animals. It is their job to fight inflation and most central bankers would be happy to entirely devote themselves to this end. Governments and politicians, on the other hand, are more concerned with employment, income, output, growth. They are often happier to see strong growth in the present even at the expense of future inflation because they are hard-wired to be short-termist. Except when the “future inflation” becomes very much a thing of the present, especially with elections round the corner. They then become desperate to reduce inflation at all costs. I suppose what I’m trying to say is that a government is far less disciplined when it comes to moderating the business cycle than an independent inflation-targeting central bank. Of course, the RBI is right to fight inflation now, election or no election. In fact, it is my opinion that they saw this wall of inflation coming ages ago and should have attempted to cool growth even earlier but may have been discouraged from doing so because of the government’s fears of of the political backlash from even lower growth. Now they’re desperately trying to reign in a price situation that is already out of control. This is what I meant by the firefighting. An inflation-targeting central bank targets a range (say 3 per cent to 6 per cent inflation). The current situation would, presumably, never have been allowed to get to this state if the RBI had been targeting a strict range set in its mandate. A more independent central bank MAY be able to produce a more stable macroeconomy.
I say “may” because even in the west, where central bank autonomy is very clearly provided for, central banks find it hard to stand firm and buck the prevailing sentiment. It’s now widely believed that a major cause of the global financial crisis was the inability of the US Fed to clamp down on the wonderful period of easy credit and high living from 2002-07. Instead, it looked the other way. Now, the Fed is falling all over itself to try to resuscitate the world economy. They are already concerned that they are following too easy a monetary policy and that the consequences of this strategy are waiting just round the corner. Yet, they haven’t been able to crack the whip. Yet.
As for the opacity of the RBI: I was referring to the absence of a) a clear mandate (eg there is no inflation target) and b) a clear policy instrument. I can think of a couple of reasons for this. One is structural: the presence of regulated prices in the banking sector. Since the government sets many floors and ceiling for rates, it becomes difficult to predict what the impact of the change in the reference rate will be on the rest of the economy (as you’ve rightly pointed out, it is very difficult to model the impact of monetary policy). As a result, the RBI uses more than one reference rate – the repo rate, the reverse repo rate (although they’re trying to align the two now) not to mention the cash reserve ratio and possibly other tools as well. We’re moving towards a more liberalised banking sector which can only help the RBI (its functioning today is already far more transparent than prior to 1991).
The second reason, as I’ve argued, is the lack of any assistance from the government. To allow the RBI to focus on inflation and the stability of the financial sector, the government must pull its weight in fixing supply-side constraints and fiscal constraints rather than make the RBI do everything for them. It’s tough to be a central bank, especially in a developing country with regulated markets. The government should not rely so heavily on a central bank to solve its problems.
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