I greatly respect Raghuram Rajan. He warned in writings and speeches of rising risks in the US financial sector in 2005-07, when all others were singing hosannas to financial innovation. The subsequent financial crisis proved him prescient.
Yet I disagree with his key recommendation as head of the Committee on Financial Sector Reform. He says the Reserve Bank of India should have a single policy focus — low, stable inflation. This is conceptually flawed and politically naïve.
In the west, some central bankers have been given a mandate to focus on inflation alone, and claim substantial success. Yet this is not a universal approach in the west — the US Federal Reserve Board, for example, aims to influence growth no less than inflation. Rajan argues in a recent column that there is no trade-off between long-run growth and inflation, and so low, stable inflation is good for growth, and also for equity (it helps the poor).
Hence he thinks the RBI should have a single objective — low and stable inflation — using a single instrument, the short-term interest rate.
This is a flawed proposition, distilling lessons from western rather than Indian experience. In a recent column, Rajan and Prasad say “it is now widely recognised that a central bank needs to control the public’s expectations of inflation in order to manage actual inflation. If workers think prices are not going to increase rapidly, they are less likely to demand a compensating increase in their wages, thus preventing an inflationary spiral from taking off.”
This happened in the west in wage-price spirals of the 1970s. But inflation in India is not driven by trade unions. The organised sector has barely 30 million employees out of a workforce of 430 million. Most of the 30 million are government employees, whose wages are set by decadal Pay Commissions, not annual wage bargaining.
The worst bouts of inflation in India have been caused by spiralling food and fuel prices, after droughts or oil crises. Such inflation cannot be tamed by changes in the repo rate.
Even in the west, central banks typically target core inflation, excluding the prices of food and fuel, which are seen as beyond the control of monetary policy. Core-inflation targeting can work because food and fuel account for only a small share of consumption in the west, and other items of consumption are more controllable by monetary policy.
But in poor countries like India, food constitutes half the budget of the poor. Even a modest rise in food prices can be catastrophic. Fuel prices matter much less, yet remain so politically sensitive that they have price controls. So, in India, core inflation is a largely irrelevant target — what matters above all is non-core inflation. Hence monetary policy is not the key to inflation, and does not set inflationary expectations.
This has been proved dramatically in the last month. Wholesale price inflation has shot up to 7.6% from 4% at the start of the year, because of booming global commodity prices. Consumer price data will come with a lag, but may be close to double digits. Nobody thinks this could have been checked by raising interest rates. The RBI — and most other observers — feel that in today’s context, higher interest rates will hit industry without reducing inflation appreciably. Monetary policy looks relatively toothless.
The government has used other policy instruments in its anti-inflation package. It has frozen the price of petrol, diesel and fertilisers, banned the export of cement and foodgrain (except basmati rice), abolished import duty on edible oils, and levied an export duty on steel. Whatever reservations one may have about these measures, they clearly have more teeth than interest rates. Indian food and fuel prices have risen much less than the world prices.
Rajan notes that to be effective, an RBI focused on inflation needs supplementary changes, notably fiscal restraint. This condition is not even close to being met. The price freeze on oil, fertilisers and food at a time of skyrocketing prices implies a huge rise in the implicit fiscal deficit, may be as much as 4% of GDP. Even a savvy finance minister like Chidambaram is readily backing price controls that imply sky-high deficits.
This drives home the political naivette of Rajan’s proposal. Indian politicians are concerned foremost with short-term electoral consequences, which — alas — require short-term fixes rather than institutional reform. Politicians will not risk an election loss in order to improve the RBI’s credibility as the guardian of price stability. Nor will Indian politicians allow any regulator to be truly independent — ministers insist on being the final decision makers.
The RBI cannot have a single-minded focus on inflation (or anything else) if it is constantly given orders by the finance ministry. Governments have multiple objectives and use multiple instruments, often at cross-purposes. This is messy. But that’s Indian democracy, and it cannot be wished away.
Today, the RBI sometimes targets inflation, sometimes the exchange rate, sometimes growth. Rajan claims that “by trying to do too many things at once, the RBI risks doing none of them well.” The main thrust of this column is that the RBI cannot be relied on to do a good job of inflation control anyway. Its main problem is not that it tries to do too many things (although that is certainly one of its faults). Its main problem is that it is far too weak and lacks the tools to control Indian-style inflation, arising from high global prices for food, fuel and other commodities. Besides, the RBI will not be allowed single-point focus or single-point authority by politicians brimming with multiple objectives, many of which are dubious.
There is no space in this column to discuss the pros and cons of the RBI trying to control exchange rates as well as prices. Let me simply say — with some regret — that Indian politics ensures that policies on both inflation and exchange rates will be set by politicians, not independent regulators. An autonomous, single-issue RBI is a pipe dream.
