We have seen this movie before

Financial Express, 7 June 2008

A jump in petroleum product prices has taken place in the context of a strong acceleration of inflation. Given that we have a poorly thought out monetary policy framework, we are now likely to get into an inflationary spiral.

All countries experience shocks to inflation. Sometimes, there is a good harvest and food prices go down; at other times food prices go up. Sometimes global crude oil prices drop, at other times global crude oil prices go up. The really interesting question is: how persistent is inflation in India now going to be? Will households and firms feel cheated at old pricepoints because the rupee is worth less? Will they raise prices of goods, services and labour with alacrity? Or will they feel that these are transitory issues and veer towards stability of prices?

If households and firms tend to raise prices of goods, services and labour, this will generate a painful inflationary spiral. High inflation will get embedded into the fabric of the economy. A high economic cost will have to paid to then wring inflation out of the system, as was seen in the mid 1990s.

Looking back at the first oil shock of the early 1970s is illuminating. At the time, macroeconomic policy in advanced countries was very poorly structured. Governments tried to respond to the inflationary shock in distortionary ways - using subsidies, wage controls, and price controls. As an example, in the US, a rationing system was put into place where cars with odd numbered plates were only permitted to buy petrol on odd numbered days!

Central bankers engaged in hand wringing about inflation, and hoped that the inflationary shock would pass. They felt that if monetary policy responded to inflation, this would hurt growth. Money supply growth rates were high. Interest rates expressed in real terms dropped sharply.

The consequences of these mistakes was catastrophic. The decade of the 1970s was afflicted with "stagflation" - a combination of low economic growth and high inflation. For economists, though, it was a period of fertile development of ideas. The policy mistakes of this period were starkly visible. Starting with a famous speech The role of monetary policy by Milton Friedman in 1968, economists put together a fundamental transformation of our knowledge of monetary economics and inflation.

From the late 1970s onwards, these new ideas were pressed into service. A new paradigm of monetary policy was put into place in Europe and the US. The key elements of this new framework included devoting the entire focus of central banks to inflation. The communication strategy of central banks switched from deliberate obfuscation and speaking in mumbo jumbo to a focus on transparency and plain English. Central banks were given political independence, but held accountable for delivering on an inflation target. These changes worked spectacularly. From the late 1970s onwards, inflation in industrial countries has been tamed. Recessions are now short and shallow. This period is now termed `the great moderation'.

The most important achievement is the anchoring of inflationary expectations. Compared with an inflation target of 2%, in the UK, at present inflation has nudged up to just 3%. Households and firms in Europe and America have unbounded confidence that inflation will remain low and stable. As a consequence, when shocks take place, they are not persistent: they do not get woven into the fabric of expectations of the economy.

There are many similarities between the experience of the US and Europe in the early 1970s and the situation of India today. An inflationary shock has taken place. In panic, the government is resorting to distortionary subsidies and price controls. Economists rooted in the economics textbooks of the 1960s are worrying about "tradeoffs" between growth and inflation, or coming up with excuses about why monetary policy is only a spectator when it comes to inflation.

The most important failures are those of monetary policy. RBI staff have made dozens of stirring speeches about how inflation is important and they will combat it. But in reality, RBI has targeted the rupee-dollar exchange rate and not inflation. From 2005 a massive expansion of liquidity took place through purchase of dollars by RBI. This was the kindling for the inflationary fire. In January 2008, inflation was nudging up, but RBI bought an unprecedented $22 billion on the currency market. After that, RBI was complicit in a sharp rupee depreciation, which makes imported goods costlier.

There is, then, a strong analogy between India of today and Western countries of the 1970s. Just as their bad macroeconomic thinking then led to high inflation and low growth, we run the risk of bad macroeconomic thinking giving us high inflation and low growth. But there is a silver lining. Just as the mistakes of the 1970s led to a fundamental transformation of monetary policy in the West, we can hope that politicians in India will now set about creating an Indian Monetary Authority which will operate a sensible monetary policy framework.

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