From fiscal dominance to currency dominance:
diagonosing and addressing India's inflation crisis of 2008

Financial Express, 15 Jul 2008

How bad is this inflation?Inflationary pressures had appeared by December 2007. In February 2008, there was a large rise in WPI Primary. In March and June, there have been massive and unprecedented increases in WPI. After monetisation of deficits was blocked in the mid-1990s, it was felt that 1970s style inflation would not recur in India. It has.

What is driving inflation dynamics? Inflation in traded goods was caused by global commodity inflation, and efforts by the RBI to weaken the rupee. Inflation for non-traded goods was caused by expansionary monetary policy. Whether we look at real interest rates or at money supply growth, monetary policy was highly expansionary.

We got a shock to primary WPI in February, and to the overall WPI in March and in June. If households and firms believe that India has a well structured monetary policy framework, these shocks will subside. If households and firms are skeptical about RBI, then a spiral of wage and price hikes will follow.

Households and firms are skeptical, and justly so. The root cause of our inflation crisis is RBI's focus on the rupee-dollar exchange rate rather than on domestic inflation. When the US dollar depreciated by 30%, RBI hung on to a fixed rupee-dollar rate. This imported global commodity inflation into traded goods in India. RBI purchased dollars on a massive scale, which injected liquidity into the economy and triggered off inflation in non-traded goods. Observers thus know that RBI cares most about subsiding exporters with a weak rupee-dollar exchange rate. Hence, we have a dangerous spiral of inflationary expectations.

What can be done to combat inflation? Monetary policy in mature market economies is about anticipating inflation and changing interest rates to respond to future inflation shocks. In India, unfortunately, monetary policy has not yet caught up with inflation data of many months ago. With inflation running at around 10%, the short-term interest rate on government bonds continues to be negative in real terms. Monetary tightening is urgently needed in order to bring the short-term real interest rate back to +2 to +3 percent.

As a first step, an immediate 50 bps rise in the repo rate and a 150 bps rise in the reverse repo rate is required. RBI needs to say that when expected inflation is around 10 percent, policy rates are going to exceed 10 percent.

While monetary tightening can and should be done, we must remember that in India, because the Bond-Currency-Derivatives (BCD) Nexus has been prevented from coming about, monetary policy is feeble. Negative real rates are pouring fuel on the fire, and this needs to stop. But if monetary tightening were the only weapon used to stop inflation, then very large increases in interest rates would be required. We saw such a story unfold in the mid 1990s: monetary policy was used to combat inflation while the BCD Nexus was still in primitive shape. Since the instrument was weak, massive interest rate hikes were required to do the job.

The BCD Nexus can and should be built through the implementation of the Mistry and Rajan reports. But in the short run, we must recognise that monetary policy in India is feeble. The really powerful tool is the exchange rate. An exchange rate appreciation would have a positive impact on inflation. Reversing the capital controls on PNs and ECB of 2007, and liberalising the capital account through measures such as placing FII investments in government bonds on par with FII investments in equities, would strengthen the rupee. In addition, selling reserves (and simultaneously reversing MSS) would also influence the rupee and simultaneously tighten monetary policy. Currency appreciation is the best tool for breaking the spiral of inflationary expectations.

What about growth? Professional economists agree with professional politicians on the importance of low inflation. There is only a short-term tradeoff between inflation and growth, and when central banks try to exploit this tradeoff, stagflation results.

The investment/GDP ratio is over 30%; the dominant factor determining growth is investment. This is shaped by the expectations of investors about India's future. With the Left out of the picture, the government must push forward with structural economic reforms over the next three months. The second tool for influencing growth is reversing all the misguided distortions that have been put in - such as banning exports or banning futures trading - in combating inflation. The third tool for influencing growth is demonstrating high quality knowledge of monetary policy. These steps will reassure domestic and foreign investors that India is on the right track, and thus bolster growth.

In the 1970s and 1980s, economists in India understood that `fiscal dominance' over monetary policy was damaging and gave high inflation. Monetisation of deficits has ended and that link has been broken. We need to now see that `currency dominance' over monetary policy is as damaging, and refocus monetary policy on the task of delivering low and stable inflation.

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