Indians tend to analyse economic events as though India was a case by itself. Yet the most causal look at our major issues inflation, economic slowdown, outsourcing, pollution, rising trade and remittances shows that they are also global issues.
Today, inflation is a problem across the world. Indians are worried that wholesale price inflation is approaching 13%, and consumer price inflation is approaching 9%. This is well above what is politically tolerable, and well above the RBI’s preferred range of 4.5-5%. The RBI has for two years been raising interest rates, and squeezing money supply through higher cash reserve ratios for banks, and open market bond sales.
Some analysts, such as Surjit Bhalla, protest that this policy is sadly misconceived and produces all pain and no gain. According to this view, tight money will hit growth and increase defaults without impacting inflation, which is mainly imported through booming global prices. After skyrocketing since early 2007, global commodity prices are now falling. This will automatically tame inflation, so the RBI should shift its focus to stimulating rather than slowing the economy, according to this view.
An opposite view comes from Friedmanite monetarists, who hold that inflation is always and everywhere a monetary phenomenon. Maybe commodity prices have doubled, but if money supply does not rise to accommodate higher purchases of commodities, people will be forced to buy less of other items, whose prices will fall. On balance, say monetarists, there will be no inflation.
I am not a pure monetarist. I believe that money matters, but that money alone does not determine outcomes. This puts me at odds with both Friedman and Bhalla. Global commodity prices are indeed a cause of inflation, in India and elsewhere.
Although financial dailies devote much space to monetary and fiscal policy, the main tools for curbing inflation in India have been trade policy and price control. The export of wheat, non-Basmati rice and (recently) maize has kept Indian grain prices much below world prices.
Import duty on edible oils has been scrapped. Export duties and arm-twisting has kept steel in India below world prices, and the current import policy for cement favours importers (who pay zero import duty and no countervailing duty) over domestic producers (who pay excise duty). Price control has kept the price of petrol, diesel, kerosene, LPG and fertilisers far below the world price, although this has serious fiscal consequences.
These measures could have terrible consequences if maintained for a long time, but in the short run have contributed greatly to inflation control. Neighbouring Pakistan suffers from 25% inflation, and so does Vietnam. The price of foodgrains in India is only 6-7% higher than a year ago, a remarkable feat considering that global prices have doubled. But this may not impress voters, who are concerned about the erosion of their living standard and are not consoled by the news that others are suffering even more.
Commodity prices have fallen sharply since early July. Given the slowdown in most economies, this trend may continue. So, should the RBI ease monetary policy, and stimulate growth? Can we say that food and fuel inflation represent imported inflation that is largely beyond the control of central banks, and so should be ignored both on the way up and down?
This is not an issue in India alone. It is an issue in countries across the globe. In many countries, central banks are reluctant to tighten money to slow growth in order to contain inflation, arguing that they cannot really tame imported inflation. Many central banks, in Opec as well as Asian manufacturing-exporters, have run up huge trade surpluses but resist currency appreciation. This tends to keep demand up and inflation high. Yet central banks persist, since they can much more easily check exchange rates than imported inflation.
This approach suffers from what Keynes called the fallacy of composition. A single central bank can legitimately argue that it lacks the power to check imported inflation, and so is better off stimulating growth. But if every country adopts this approach, the consequence will be global inflation stoked by central banks.
Any single country may import inflation, but the world as a whole cannot iport inflation. Higher prices are not imported from Mars. They come from the actions of central banks and governments. So it is a serious mistake for any large country — including India — to feel that it cannot check imported inflation.
The US Fed has kept short-run interest rates extremely low at 2% to prevent a recession, even though inflation is running at 5.6%, the highest rate since 1991. China too has a negative real interest rate. It has tightened nominal interest rates for two years and raised the cash reserve requirements of banks to a huge 17%. Yet many economists — such as Arvind Subramaniam and Adam Posen in a recent op-ed in The Financial Times — accuse China of a loose monetary policy, arguing that China aims above all to resist currency appreciation through massive forex reserve accumulation. This artificial cheapening of the yuan is inflationary.
Subramiam and Posen argue that the US and China are currently refusing to share a reasonable part of the pain involved in inflation-fighting. Their monetary policies are much too loose, and they are free-riding on the inflation fighting efforts of others (notably the EU, India and Brazil). The two economists want co-ordinated central bank action to tackle inflation. Specifically, they want the US and China to do much more.
While agreeing, I would add two caveats. First, don’t overstate India’s inflation-fighting virtues: at 9%, its repo rate is negative or almost negative in real terms. Second, don’t overstate the looseness of US monetary policy: its structural credit crunch constrains lending even though interest rates are low.
What are the chances that we will really get purposive global action against inflation? Not high. Rich countries face recession, and politicians there will happily risk some inflation to save jobs and incomes. So, expect inflation to remain high despite falling commodity prices.