Partha Sen writes: The inflation tightrope

The Indian economy has been hit by inflationary shocks of late. The inflation target of the Reserve Bank of India is 4 per cent, with a band of 2 per cent on either side. However, the RBI did precious little to try and lower the inflation rate given that it was at or above the upper threshold of 6 per cent since the beginning of this year. Only after inflation hit 7 per cent did it raise the repo rate. So how will this episode pan out?

The fact that some part of inflation is coming from abroad is an added complication. There has also been a steady outflow of foreign funds from the stock market. This could cause the rupee to depreciate, in turn, raising the prices of imported goods (for example petroleum products), thereby adding to the inflationary woes. The RBI has raised the cost of borrowing (by 90 basis points so far), with a promise of more to come. The central government has cut fuel taxes with alacrity, and has banned the export of certain items. Knee jerk reaction galore. But do our policymakers have enough arrows in their quiver?

Supply shocks pose a problem for the authorities. If output is stabilised using macroeconomic policies, prices will rise even more. On the other hand, if they stabilise prices, output (and employment) will fall. It is argued by mainstream economists that discretion in policy making is used by politicians for their narrow partisan ends. Inflation targeting is rules-based. Monetary authorities raise interest rates if inflation is above the preferred target, and vice versa. Actually, interest rates should rise more than inflation so the “real” interest rates rise, causing a compression in demand (and a fall in economic activity), which in turn will reduce inflation. The RBI embraced this idea. In 2016, an independent monetary policy committee was constituted. Until recently, the inflation rate was well within its target range, but with the supply side shocks (originating from food and oil primarily), all hell has broken loose. I feel that in a bid to follow international best practices, the RBI seems to have fallen for a fashionable framework hook-line and sinker, without thinking about the structure of the Indian economy. I want to highlight two points.

The first point relates to agriculture’s role in the Indian economy. India’s non-food and non-oil components of the consumer price index CPI are about 47 per cent. In comparison, for the ECB, it is less than one-third of the CPI. Of course, the RBI has no control over international prices of food and oil, so it must squeeze less than 50 per cent of the domestic economy to lower inflation. As mentioned earlier, the real interest rise works through demand compression. But the problem is on the supply side. Also, as compared to the RBI, the ECB would suffer a lower rise in inflation, and has a larger menu on which to apply demand compression.

The second point is the silence on the exchange rate and its effects on output. Until the 1970s, the accepted wisdom was that an economy had to achieve both internal balance and external balance. The former consisted of full employment and low inflation using monetary and fiscal policies. The latter objective required a balanced current account over some horizon (“don’t get too much into foreign debt”), by using, for example, the exchange rate. Over time, the internal balance has come to mean, from a policy perspective, low inflation, since “the market” will ensure full employment (put on hold during the global financial crisis and the Covid-19 outbreak). For the OECD countries, the external balance was not a constraint any longer, since they had made their currencies fully convertible, and international capital flows were unrestricted.

But is this true for India? If it were so, no one would be interested in discussing the country’s foreign exchange reserves, because these could be generated instantaneously by exchanging the domestic currency for foreign exchange. Until 2020, India had seen massive portfolio capital inflows (when OECD interest rates were low), and its current account deficits were financed by foreign reserves. But portfolio inflows can, and do, reverse themselves. In about six months, the foreign exchange reserves have fallen from around $640 billion to around $600 billion. FII inflows also contribute to India’s lack of competitiveness. The RBI bought foreign exchange (with rupees). But fearing this would stoke inflation, it sold government bonds, and removed the excess liquidity. This “sterilised intervention” saw the RBI’s foreign exchange assets going up, matched by a reduced holding of government bonds. Thus, India’s foreign exchange reserves were not its “own”— there were liabilities against it. This is unlike foreign exchange reserves accumulated by running current account surpluses (for example China). The FII rush into India created an “exchange market pressure”. The RBI could have let the rupee appreciate or have accumulated foreign reserves. It chose an intermediate solution — a mix of an appreciation and accumulation of reserves. The appreciation caused by inflows reduced international competitiveness for Indian products. In effect, we had our own episode of the “Dutch Disease”.

To go back to inflation targeting. As the RBI raises interest rates, outflows will possibly slow down with the rupee appreciating. That is not good for external balance. It is easy to see that inflation targeting could be at odds with external balance. Our commerce minister has reportedly said that India is a current account deficit country, and, therefore, a depreciation is bad, since it makes imports more expensive. Words fail me here. If inflation does prove stubborn, and fighting inflation is all that the authorities in India worry about, we could see an external crisis. Sounds far-fetched?

The writer is former Director and Professor of Economics, Delhi School of Economics