Reddy and Bernanke

Business Standard, 1 November 2006

Monetary policy is at a difficult juncture, in India and outside it. On balance, RBI is on the right track by being hawkish about inflation. Inflation in India has risen far beyond acceptable levels, and more dangerously, the very credibility of monetary policy is undermined when the economy thinks that the central bank won't respond to a sharp rise in inflation. What India needs most today is for RBI to set course for getting back to the 3% inflation of late 2003.

In India, there are difficulties in inflation measurement. Unfortunately, both the CPI and the WPI have severe methodological and operational problems. But between the two, the CPI is clearly the better measure. The CPI basket is the genuine consumption of some households in India - while the WPI basket lacks such a foundation. Hence, it is preferable to utilise the CPI, even though it has inferior timeliness and frequency.

CPI (IW) inflation had dropped to below 3% in late 2003. From there on, inflation has steadily accelerated, reaching very high values of 6% to 7% in recent months. This constitutes an acceleration of inflation of 300 to 400 basis points. Interest rates have not risen by a commensurate amount, so effectively real rates have dropped.

High GDP growth in the aftermath of such a sharp reduction in real interest rates - an expansionary monetary policy - is hardly surprising. This episode has served to undermine RBI's credibility as a central bank. Such episodes increase inflation persistence, by giving households and firms the idea that when inflation spikes up, monetary policy will not react correctly to it.

The picture of monetary policy in the US has been more cloudy. In recent years, there have been divergent views about the US economy. Many economists from the research community have been much more gloomy about the outlook, when compared with economists on Wall Street. In 2006, the pessimists have been proved right.

Growth in the US first faltered in Q4 2005, with 1.8%, but it bounced back to 5.6% in Q1 2006. From Q1 2006, a sea change has come about on the US housing market. GDP growth dropped to 2.6% in Q2 2006 and further to 1.6% in Q3 2006. There were some statistical difficulties with the Q3 data on the automobile industry, so some independent analysts are interpreting the Q3 number as being more like 1% growth. This is a dramatic change in fortunes, from 5.6% in Q1 to perhaps 1% in Q3.

Private residential investment, which did well till Q2 2005, has been the main source of growth deceleration in the US thereafter. This element turned in numbers of -11% in Q2 2006 and then -17% in Q3. Looking forward, two kinds of effects will be felt. First, problems in US housing could deepen, and private residential investment could continue to drop. More importantly, the drop in housing prices will feed into lower consumption in coming quarters. So far, US personal consumption growth decelerated from 3.4% in Q1 2006 to 2.1% in Q3. The outlook for the US economy now hinges on how this will evolve in the quarters to come. Many economists expect consumption growth will turn negative, in the aftermath of the housing shock.

How will the US Fed react to these developments? Nobody knows which way the game will go. On one hand, the softening economy could generate pressures to cut rates once forecasted-inflation drops sharply. But inflation has stayed stubbornly high. The US Fed has an inflation target of between 1% and 2% inflation. For many quarters now, forecasted-inflation seen in the market for inflation-indexed bonds has been above 2%. Bernanke needs credibility for his next 10 years as Fed chairman, and the way to get that credibility is to get inflation below 2%, by running a tight monetary policy.

But how much does US GDP matter to us in India? It matters greatly. In the olden days, Indian GDP growth was about the monsoon. But agriculture is down to only 20% of GDP and dropping fast, and important parts of agriculture are now immune to the monsoon. Now India has a business cycle, the likes of which are found in market economies. India also has substantially open economy: gross flows on the current account and the capital account added up to 91% of GDP in 2005-06. Hence, US GDP, which exerts a major impact on world GDP, matters greatly to India. A slowing in US GDP growth will inexorably affect us.

A sharp acceleration of inflation in India plus a distinct slowdown GDP growth in the US: How should RBI put these factors together? This situation highlights one key point: there is a difference between the Indian business cycle and the US business cycle. The US is teetering in a complex decision between tightening and easing. In India, the unambiguous requirement is of tightening. The monetary policy woven in the US, for the needs of the US economy, by the US Fed, is not the appropriate monetary policy for us in India.

RBI's first dharma must be the domestic business cycle; RBI's first goal must be to get India back to the remarkable achievement of 3% CPI inflation of late 2003. Even though inflation was brought down to 3% then, there seems to have been no institutional effort at hanging in there, and inflation has once again gone out of control.

There are long lags between monetary tightening and its impact on inflation, particularly because RBI carries little credibility in the eyes of households and firms when it comes to being serious about inflation. Coincidentally, the time horizons for battling inflation coincide well with the date of the next general elections. Hence, what makes the most sense for the UPA and for the RBI is to focus on an inflation target of 3% to be achieved by late 2007.

Raising rates could induce higher capital inflows and put pressure on the rupee to appreciate. That is perfectly okay, in terms of macro policy. It is far more important to have a credible central bank, and achieve low and stable inflation, than it is to achieve a desired exchange rate. Achieving stable 3% CPI inflation is a prize which is within reach of the RBI.

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