Don't get spooked by the inflation
Business Standard, 16 December 2019
Inflation has risen, particularly with a sharp rise in vegetable prices. This is not, however, a time to get too worried about inflationary pressures in the economy. RBI is on the right track on what is being done in monetary policy. The problem lies in the financial system: the attractive interest rate at the short end of the yield curve for government bonds is not translating into attractive interest rates for many borrowers in the country.
Food and beverages (F&B) make up about 45% of the weight in CPI, and F&B inflation has gone up from about zero (year-on-year) in early 2019 to about 8.7% in November. This has helped give an acceleration of the overall CPI inflation from about 3 per cent to 5.5 per cent. Many are worried about the outlook for monetary policy.
Even under ideal circumstances, monetary policy acts with a long lag. So when we think about the decisions of the MPC, we should not respond with a lag to the information about the past, we need to peer into the future, into conditions in the economy in late 2020, because that is what monetary policy is useful in influencing.
An important element of the present inflation is vegetables. Vegetables have a 6% weight in the CPI, and year-on-year inflation in November was 36%. But vegetables are characterised by rapid cycles of high and low prices. The time from sowing to harvest for a tomato, for example, is about 90 days. As a consequence, price changes rapidly kick off supply responses.
As an example, consider the previous surge in vegetable prices, which took place in late 2017. Vegetables inflation peaked at 29% in December 2017. But this was followed by a rapid supply response, and vegetables inflation was back into negative terrain by July. A scant seven months after the peak (29% in December 2017), vegetable inflation was negative (-2% in July 2018).
When tomato prices surge, private persons put more land to work growing tomatoes. Numerous other responses also kick in. Private persons spend more on agricultural inputs such as labour, and on tender care of the produce after the point of harvest. As an example, when prices are high, private persons will spend more on electricity or diesel and payments for cold storage, so as to reduce the rate of depreciation of the produce. These changes in behaviour kick in even for land that was sowed earlier. If a tomato plant is 60 days old, and the price of tomatoes on the market is very attractive, greater effort is put into the plant from that point onwards, which makes a significant difference to the final supply response.
It is likely that this will happen again, now. High vegetables inflation in November will have kicked off a supply response, and in a few months, vegetables inflation will be back down to modest values. The main issue in thinking about monetary policy today is our forecast for CPI inflation in late 2020, and high values of vegetables inflation in November 2019 should not significantly alter our forecast for CPI inflation in late 2020.
These aspects were well understood in the design of the monetary policy framework. This is what gave the target zone, from 2% to 6%, rather than just a 4% target. We should hold RBI accountable for delivering 4% CPI inflation, but expect that there will be fluctuations around this target within the specified range from 2% to 6%. Roughly speaking, when we see a CPI inflation outcome of below 2% or above 6%, we should know that mistakes were made a year or two earlier, and we should undertake a post mortem to better understand what went wrong, and how the processes can be improved.
There are many instruments of monetary policy, so it is important to look beyond headline monetary policy (the repo and the reverse repo rate). All the levers of monetary policy come together and shape conditions in the 91 day treasury bill. That interest rate is the best summary statistic about what monetary policy is doing. As the graph shows, in early 2018, the MPC felt that a tightening was required, and raised rates by about 100 bps. From this peak of 7%, there has been a strong easing of about 300 basis points.
The de facto policy rate is thus at about 1 per cent in real terms, which seems about right. There is a problem in the economy, where many borrowers are paying very high rates. This is a problem of financial policy, not monetary policy. There is headroom for cutting rates in the future, reflecting the difficulties of the economy, and I suspect we will see the policy rate go lower. But in the short run, changing the stance of monetary policy will not make a big difference to the places in the economy where very high interest rates are being paid.
Many interest rate assumptions, in the Indian economy today, are at values which are out of touch with the 4% inflation target. Administered rates of return need to be at 5 per cent, i.e. 1 per cent real, but they are at 8 to 9 per cent. The nominal GDP growth assumption that goes into the budget process, needs to come down to lower values, reflecting 4% inflation. Bringing down these values is immediately feasible, and will help significantly.
The problem of the economy is a reflection of weak business cycle conditions layered on top of a decline in trend growth. We had high trend growth from 1991 to 2011, but lower trend growth thereafter. Monetary policy is a useful lever for dealing with the business cycle fluctuations, but not the decline in trend growth. By and large, monetary policy today is on the right track, performing its function of delivering 4% year on year CPI inflation, which is the most that monetary policy can do. We should not be worried about the recent rise in inflation, or about the present conduct of monetary policy.
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