Last week was the first meeting of the Monetary Policy Committee (MPC) constituted under the inflation targeting framework agreement between the government and the Reserve Bank of India (RBI). The objective of inflation targeting is "primarily to maintain price stability while keeping in mind the objective of growth". There is obviously some contradiction between the two objectives, at least in the short/medium term. Those that readily come to mind are presented here.
> If money supply is reduced and interest rates are hiked (or kept high) in order to bring down inflation, this reduces growth - at least in the short run. In the long run, as Keynes argued, all of us are dead anyway.
> There is also a conflict between the domestic and external values of the rupee: An overvalued exchange rate may be helpful in bringing down inflation, but also leads to output/growth loss.
> With Consumer Price Index (CPI) as the target measure, if the gap between the targeted variable and the Wholesale Price Index (WPI) grows unduly large, as had happened recently, real interest rates become too large for businesses to live with, which in turn affects the non-performing assets of the banking industry, business investment, and the banking system's willingness to lend.
It will be interesting to see how the various conflicts are handled by the MPC in the coming months, under the leadership of the new RBI governor. But last week's decision to reduce the repo rate, as also the targeted real rate, is to be welcomed, given that the Indian economy needs to grow even faster to create employment for the increasing population. It is worth remembering that around 12 million people are entering the job market every year. To be sure, the percentage of unemployed people has been around five per cent, according to the official statistics, but one presumes the rag-picker, working a couple of hours a day, is considered self-employed!
Coming back to disinflation measures and the "sacrifice ratio", I recently came across a paper titled, "How Costly is the Deliberate Disinflation in India?", co-authored by Professor Ravindra Dholakia of the Indian Institute of Management Ahmedabad, who is also a member of the MPC. Quoting from an interview by the previous RBI governor in Mint (2014), the paper argues that "there is serious confusion among practitioners and policymakers in India based on the argument that there is no long-run trade-off between inflation and output". On the other hand, it refers to a 1999 paper by L Ball titled, "Aggregate Demand and Long-Run Unemployment", Brookings Papers in Economic Activity, which says that "countries that have followed counter-cyclical expansionary policies have not only achieved a reduction in unemployment levels, but have also been able to rein in inflation in levels similar to countries that have continued the tight policies even in the face of recession". The paper itself argues that, "perceived gains of low inflation in terms of higher economic growth and distribution often outweigh the real costs of output loss and increased unemployment incurred to lower the inflation rate". Using regression analysis and data for different periods and various inflation measures (gross domestic product deflator, CPI, WPI) the paper estimates the sacrifice ratio to be between 2 and 3.8. The implication is that the economy pays a heavy price in terms of output loss and increased unemployment for bringing down the inflation rate.
At this point of time, it is not clear whether the minutes of the MPC would be published, and if so, in how much detail. But this apart, it may be useful if the MPC asks the central bank's economics department to undertake a study on the impact of demographics on inflation. One has not come across much published literature on this issue.
Margaret Thatcher & Theresa May
Both are Conservative Party leaders and UK prime ministers, one former, the other current. But the difference in their ideologies and perspectives was highlighted in Theresa May's speech at the party conference last week when she criticised the capitalist elite and asserted that monetary policy of the last decade has made "people with assets … richer". She also hinted at increased government spending and borrowing for new infrastructure projects. (After her speech, finance capital started leaving the UK and the pound fell even before last Friday's "flash crash".) Her policy announcements included a review of workers' rights, new housing schemes, a promise to take on "Big Business" and to turn the Conservative Party into a workers' party.
Thatcher must be turning in her grave - and surely some Conservatives are regretting their choice of the new leader.
The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com
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