Trading Growth for Inflation

Earlier this month all eyes were on Reserve Bank Governor Duvvuri Subbarao. Every statement of his was read as signalling whether he would raise interest rates and by how much he would do so this time. With the economy having bounced back and GDP growth approaching previous peaks, the presumption was that the focus of the governor's attention would be the persistent and unacceptably high inflation. He would, therefore, be willing to sacrifice investment and growth, the pundits argued, by raising interest rates so as to moderate inflation.

There is no single interest rate in any economy. To raise interest rates, the central bank has to select and change a particular rate, which, in turn, is expected to move other rates in the same direction. For some time now the relevant rate in India has been the repo rate or the rate at which banks borrow money from the Reserve Bank of India (RBI). An increase in the repo rate by increasing the cost at which banks can access short-term capital is expected to induce them into raising their lending rates and the rates they pay the depositors from whom they mobilise much of their capital. Besides this, a change in the interest rate would affect variables such as the prices of assets (stocks and housing) and the exchange rate. But the main channel through which interest rate adjustments are expected to work their way through the economy to reduce inflation is through the impact that the policy rate has on various commercial interest rates, such as those for mortgages, for consumer loans, as well as for deposits.

In its most recent monetary policy statement, the RBI has met analyst expectations by raising the repo rate by half a percentage point (or 50 basis points) from 6.75 to 7.25 per cent. It has not opted for any other measures such as attempting to pre-empt lendable resources by raising the cash reserve requirement (CRR) imposed on banks. The central bank is clear about the intent of its manoeuvre. Its statement issued on May 3 notes: "Over the long run, high inflation is inimical to sustained growth as it harms investment by creating uncertainty. Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence."

To those not familiar with the discourse on economic policy, this move must have been surprising for just one reason. Over recent months, the Governor has more than once raised interest rates in order to rein in inflation. Yet inflation, especially food price inflation, has been stubbornly high, even if moderating in recent months. Clearly, monetary policy in the form of a hike in the interest rate has not been an effective weapon against inflation.

According to its advocates, a hike in interest rates is expected to have a number of effects, including a fall in investment because of the higher cost of capital, a rise in saving because of more attractive returns, and a reduction in credit-financed consumption because of the rise in the cost of credit. The resulting contraction in demand (and growth) is what is expected to moderate inflation. The argument is premised on the grounds that the central bank can influence the relevant interest rates with its policies and that high inflation is the result of an excess of expenditure relative to supply, determined by the volume of available output and imports, which a hike in interest rates could correct. To the extent that these premises are not valid, monetary policies in general and interest rate changes in particular will fail to have any impact on the rate of inflation.

There are three reasons why they could be wrong. The first is that the presumed transmission of the effects of changes in the repo rate to other commercial rates that matter may not occur. The RBI has in the past been concerned that there is inadequate transmission of the effects of interest rate policy, though it feels that matters have improved considerably recently.

The second is that even if the rate hike is more-or-less generalised, its impact on investment, savings and consumption may be too weak to make a difference. However, in recent years the belief has been that even if the impact of an interest rate hike on productive investment is limited, it would substantially squeeze credit-financed investment in housing, and credit-financed purchases of automobiles, durables and commodities, dampening demand and growth, with attendant effects on prices.

The third reason is that price increases may not be the result of demand-supply imbalances caused by excess expenditures relative to available supplies. This does seem substantially true in India, especially with respect to food. It cannot be denied that the long-run neglect of the food economy in India has slowed production increases and provided the basis for supply-demand imbalances when growth recovers or accelerates. But two factors have limited such potential imbalances. To start with, when GDP growth occurs, its benefits tend to be unequally distributed, with households whose consumption basket is dominated by food items being the selective victims of budgetary cuts. Further, in recent years India has had ample reserves of foreign exchange to import commodities in short supply and correct supply-demand imbalances.

If the economy has still been experiencing inflation, it seems to be the result of two other factors. One is that domestic prices are increasingly tied to global prices partly because of the liberalisation of trade and partly because administered prices are increasingly calibrated to correspond to international prices. This link between domestic and international prices has meant that the rise in the prices of fuel, food and intermediate prices in international markets has been transmitted to India as well, with the government doing little to restrain this "imported" inflation. As the RBI's Third Quarter Review of Macroeconomic and Monetary Developments notes: "High global crude oil and other commodity prices pose the biggest risk to India's growth and inflation. Persistently high inflation has kept inflation expectations elevated. Fresh pressures from commodity prices do make 2011-12 a challenging year for inflation management." If inflation is influenced by global developments, adjusting domestic interest rates may do little to redress the problem.

The second reason for persisting inflation is that the liberalisation of domestic trade, a reduced emphasis on public distribution and the freedom given to traders in commodities and futures markets, have encouraged speculation and induced an element of upward buoyancy in prices. It is indeed true that a hike in interest rates, by increasing interest costs on borrowing to finance speculation, could help dampen speculation. But if the hike in interest rates is small relative to the returns expected from speculation this may be an inadequate disincentive.

Factors like these could explain not just the persistence of inflation, but also the failure of past attempts to hike interest rates to rein in inflation. If inflation is imported and has little to do with immediate demand-supply imbalance, contracting demand would not help. What the hike in interest rates would do is increase the repayment burden on loans taken to finance household investment and consumption, especially investment in housing. The evidence shows that personal loans that were an important driver of growth before the financial crisis of 2008 have seen a revival recently. Aggregate personal loans provided by the commercial banking sector rose by 17 per cent in 2010-11, as compared with 4.1 per cent in 2009-10. Within this category, the growth during 2010-11 in housing loans stood at 15 per cent and in loans against consumer durables at 22.4 per cent, as compared with 7.7 and 1.3 per cent respectively in 2009-10. Those taking on these loans would have in recent months been faced with significant increases in the equated monthly installments they pay. This would not only discourage further borrowing and new borrowers, but can lead to defaults. Given the relatively high shares of personal loans in the aggregate advances by banks, it could discourage lending as well. So a contraction of demand and growth is a real possibility.

Thus, while the RBI's interest rate manoeuvre may end up being successful in contracting demand and growth, it is likely to fail to rein in inflation. If that transpires it would be the result of using not just an inadequate but a wrong instrument to address the problem at hand.

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C. P. Chandrasekhar MRZine

C.P. Chandrasekhar is Professor at the Centre for Economic Studies and Planning at Jawaharlal Nehru University. This article was first published in MacroScan on 27 May 2011; it is reproduced here for non-profit educational purposes.