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Inflation
Tuesday, April 17, 2007
The inflation fighters in the Reserve Bank of
the expected - and stronger than expected - countermeasures to fight
inflation. Inflation has been running at above 6 per cent measured by
the wholesale price index and is above the comfort level adjudged by
the RBI and the Centre.
The decisions announced by the RBI include a rise in repo rates (the
rates at which banks borrow from the RBI), a rise in cash reserve
ratio and a reduction in rate of interest on cash deposited by banks
with RBI. The signals are intended to spur banks to raise lending
rates and to reduce the amount of credit disbursed. The RBI's measures
are expected to suck out a substantial sum from the banks. In effect,
while the economy is booming and the credit needs grow, the central
bank is tightening the availability of credit.
A cancer specialist does not or should not care too much for the
comfort of the patient when he or she prescribes chemotherapy.
Similarly, has the RBI proved too enthusiastic at prescribing severe
chemotherapy to starve out the tumour that is inflation? It may weaken
the healthy cells as well. The shocked market analysts and economists
have been at pains to analyse the various implications of the central
bank's action and the possible alternatives.
The markets have signalled their resounding reaction by a sharp fall
in the Sensex by nearly 500 points. The impact on economic growth is
also likely to be sharp, judging by effects of similar therapy applied
with disastrous effect in the mid-1990s.
Did the RBI have an alternative to its `shock-and-awe' tactics? Could
it not have waited for the crop harvests to come in and the effect of
seasonal adjustments to play themselves out? It is admitted by all and
sundry that the rate hikes will take some time to act on inflation. By
then, the eagerly awaited wheat harvest would have come in and the
effects of supply responses would mask the direct impact of RBI's
actions.
It would, however, reduce the level of investment activity in the
economy, particularly in the infrastructure sector. Big corporates may
ask for, and get, access to external commercial borrowing, but not so
favoured are the bulk of small and medium entrepreneurs. Governments
will also face the risk of rising interest costs. Housing activity
will suffer an impact because most loanees are on floating rates and
will face increased equated instalments. Perhaps, an effect desired by
the RBI - a slowdown in housing expansion - will come to pass.
Radical alternative
In a seminal interaction in a recent media debate, Dr Ila Patnaik has
pointed out that the present policy problem demands a rethink of the
framework of the monetary policy-makers. Dr Patnaik says the RBI
pursues conflicting objectives in its currency interactions (which
involve purchase of dollars for rupees) and its contractionary stance,
as evidenced by recent measures.
The RBI buys dollars from banks and exporters, partly to prevent the
dollars from flooding the market and depressing the dollar -
indirectly raising the rupee. In other words, the central bank's
interactions have a desirable objective - to keep the rupee devalued -
which will make
liquidity.
To combat this, the RBI does what it calls "sterilisation" - it sucks
out the rupees it pays out for dollars through sale of sterilisation
bonds. It then sells these bonds to banks. Dr Patnaik points out that
there has not been much success in such sterilisation attempts in
has not been too successful inasmuch as the banks sell the bonds and
get rupees instead.
Dr Patnaik contrasts this with the successful experience of
where the state-owned banks strictly abide by the central bank's
dictates and absorb the sterilisation bonds. That discipline is
lacking in
indirect methods of sterilisation, such as raising interest rates and
raising CRR to contract liquidity. This makes
for foreign capital flows that seek better returns and a vicious cycle
follows. RBI has to buy more foreign currency and sterilize. The cycle
becomes worse.
Dr Patnaik suggests a radical alternative, viz. that RBI should
rethink its currency policy, which results in flooding the markets
with rupees. She admits that cessation from direct intervention in the
foreign currency markets will lead to rupee appreciation, which may
hurt
exchange rate is nominal exchange rate minus inflation. Higher
inflation mops up the competitive advantage of a weaker rupee.
In Dr Patnaik's opinion, the RBI should explore the possibility of a
different policy mix, which leads to the central bank having a
calibrated control over money supply as well as exchange rate. An
appreciating rupee may also lead to lower inflation.
Dr Patnaik further points out that "while inflation is relatively
high, at 6.5 per cent, it does not yet appear to run away completely
out of control. In contrast, monetary policy, with call money rates
going above 70 per cent, seems to have been lost control of. Neither
is the policy able to provide stable conditions in financial markets,
nor is it able to control inflation".
Transparency
She explains this further, pointing out that "money gets created in
two ways". First, when the RBI buys a dollar with rupees, it creates
rupees. Second, when the RBI lends to the government, it creates
rupees". For many years now, no rupees have been lent to the
government by the central bank. The bulk of money circulating in the
economy increases mainly by dollar purchases by the Bank. It is dollar
purchases that created the bulk of liquidity between April 2006 and
January 2007. The RBI has added liquidity through the sale of the
order of Rs 56,000 crore.
Dr Patnaik is an experienced economist and reputed analyst of monetary
policy. She pleads for greater transparency in the RBI's sterilisation
operations. Basically, Dr Patnaik's alternative policy mix is a
holistic one with a focus on inflation control without too much
emphasis on interest rates. She believes that this change of emphasis
will enable the central bank to avoid a confusion of objectives and
control inflation while maintaining adequate growth. By all means, let
the RBI's fight against inflation continue. But there should be a
clear paradigm to adopt. The US Fed Reserve, which is the RBI's model,
does not have resort to CRR. The control is through the price of money
- that is, interest rate, and not the quantity.
The Fed does not sequester resources of the banking system by raising
CRR for it has zero CRR. Even if the Fed's monetarist model is
followed, one has to allow borrowers to get credit at least at a
price. Both quantity and price cannot be controlled at the same time,
which is what the RBI is doing.
are also other voices of reason that have pointed out the
contradictions in the RBI's present policy mix-up. "Fight inflation,
by all means. But do not destroy growth prospects of the economy".
