The Third Quarter Review of Monetary Policy by the Reserve Bank of India has revisited the growth-inflation trade-off, calling it a ‘False Trade-off’ and giving priority to inflation. As such, the policy repo rate has been increased to 8 percent from 7.75 percent. The RBI has recognised the slowdown in industrial growth and has blamed inflation as the main culprit for this slow-down, justifying thereby its move to control inflation. It has clearly demonstrated its ’One-Target (inflation)- One-instrument (interest rate)’ approach through this review.
While the approach itself is not questionable, can the growth-inflation trade-off be dismissed as ‘False’?
There exists enough RBI empirical work to suggest the existence of such a trade-off in the form of a sacrifice- ratio (i.e. the percentage of growth that has to be given up for controlling inflation). Now, are we to take it that the RBI, under the leadership of Governor Rajan, has some other evidence to the contrary?
Governor Rajan has spoken of a disinflationary process to take effect by 2015/2016. Would such a process be policy-driven or whether it would result merely on account of a high inflation in the corresponding period of the past ( the base effect), one wonders!
The review states that the “gravest risk” to the value of the rupee is from CPI inflation. It is rife with ‘Motherhood statements’ regarding the ills of inflation. Unfortunately, despite RBI’s concerted efforts in the past, inflation persists. It is clearly evident, that the RBI has been barking up the wrong tree, when increasing the interest rates in the past.
While the food inflation has come down, it is more a seasonal effect, coupled with a base effect. The potential threat of high food inflation remains. Past evidence suggests that monetary policy through interest rate hikes to control Aggregate Demand has been largely ineffective.
While the Governor seeks to draw comfort from the reduced external sector Current Account Deficit (CAD), the fact remains that a 2.5 percent CAD in a 5-6 percent growth scenario is clearly unsustainable, as per the RBI’s own research conducted earlier. Moreover, this reduction in CAD is in part a reflection of the low growth (leading to lower non-oil imports) and partly on account of an artificial restriction on gold imports.
The slow-down in growth is expected to be exacerbated further through fiscal tightening. The unemployment resulting from such lower growth seems to have been overlooked in the rejection of this growth-inflation trade-off. Among BRIC countries, India has the highest unemployment rates at 9.9 percent, compared to the 4-5 percent in other countries.
Governor Rajan speaks of inflation curbs without ‘substantial’ sacrifice to short-term growth and asks for patience. The point remains- what is short and what is ‘long’ from the human perspective? For, are we not all dead in the long run?
(The authors are Professors at the S.P. Jain Institute of Management & Research, Mumbai. Views are personal. )
Following are the highlights of the Reserve Bank of India’s Third-Quarter Review of Monetary Policy for 2013-14 (Apr-Mar):
n CPI declined significantly but still remains elevated
n Must address inflation risks while recognising weak economy
n Upside risks to central inflation forecast of 8% remain
n If policy action succeeds, GDP growth may firm up FY15
n Some domestic growth momentum loss likely Oct-Dec despite pick up in rabi sowing
n FY15 growth may be in range of 5-6%
n Financial market contagion is clear potential risk
n Industrial activity remains in contractionary mode
n Consumption demand still weak
n Low capital goods output points to stalled investments
RK Pattnaik & Tulsi Jayakumar