A suggestion to the IMF on inflation

Standard policies towards inflation have not helped. It is important to think out of the box

Inflation in Turkey is at a very high 55 per cent (it was even higher at 83 per cent a few months back). The inflation rate in countries like Sri Lanka and Pakistan is also alarmingly high. What should be the policy?

The central bank should raise interest rates. This is at the heart of the usual policy prescription. However, high interest rates can lead to high interest costs. Though this cost-push factor is less familiar compared to the effect of, say, higher oil price, it can be bad enough. Higher interest costs by themselves only aggravate inflation, not reduce it, as President Recep Tayyip Erdoğan in Turkey has repeatedly emphasised, though he does not offer a meaningful alternative policy.

Also, high interest rates can encourage international capital inflows that will stay only till the high interest rate policy is in place. Subsequently, there can be a sudden, large and painful reversal of capital flows once the withdrawal of the high interest rate policy is in sight. Moreover, these changes in interest rates can, ceteris paribus, destabilise asset prices. Furthermore, very high interest rates can almost kill economic growth and employment for a significant duration. Finally, exorbitant interest rates can seriously increase the interest burden for a group like home buyers.

We can now come to the alternative policy package proposed here. This includes, broadly speaking, four unorthodox policies.

First, under the proposed policy the central bank does not raise interest rates, but it does slow down the rate of growth of money. Now it is true that the demand for central bank money will be high at relatively low interest rates. So, the market for funds will not clear if the money supply is not expanded much. However, the central bank can shift to significant rationing. Since it is proposed that the rate of growth of money is slowed, this will have a gradual effect on controlling the inflation rate. And, since the interest rates are kept in check, the inflationary push due to higher interest costs will be nearly absent. In fact, the interest rates may be even reduced slowly!

Second, it can be that real investment is high and this is contributing to the demand-pull inflation. This appears to be the case at least in Turkey. A small tax can be imposed on companies that are undertaking real investment. This should keep a check on spending and on inflation. The tax on real investment, if needed at all, need not be large because in any case the availability of funds is constrained, given the inflationary environment and given the effect of the above suggested policy of slowing down the rate of growth of money.

Third, it is true that under the proposed policy, as the central bank implements the policy to not raise interest rates even as inflation continues, the relatively low interest rates can induce capital outflows, weaken the domestic currency, and make imports more expensive. This can, in fact, come in the way of controlling high inflation. To deal with this issue, it is advisable that a tax is imposed on capital outflows under the proposed policy package. This is consistent with the idea of taxing negative externalities due to capital flows. 

Finally, the savers can be given a subsidy on their interest income by the treasury, given that interest rates are not being raised and inflation remains high. The subsidy is realistic, as the policy package includes additional taxes as well.

It is true that the suggested policy package has its own inconveniences or difficulties. But we cannot have a painless solution! What we can do is to choose the less painful solution. In any case, the record of policy advice from a body like the International Monetary Fund (IMF) needs significant improvement. Ideologically, it may help to state that the ideas on temporary rationing of funds and temporary tax-subsidy schemes here are parts of the second-best solution. These should not be confused with regular government intervention in an economy with emphasis on state planning. Of course, it helps to have political stability when we are considering economic policy.

Let us leave aside the non-economic reasons that President Erdoğan in Turkey may have. But he is right in saying that high interest costs add to the inflationary pressure and for this reason the interest rates should not be raised. Now it is true that the IMF cannot accept his view as the President has not offered an alternative meaningful policy package. This column has.

The basic policy solution here is not just for Turkey but also for other countries like Sri Lanka and Pakistan, which are battling high inflation. In fact, it may be considered even more generally.

The writer is visiting professor, Ashoka University. gurbachan.singh@ashoka.edu.in. Nikhil Vuyyuru contributed to this column