By - Pranjal Rawat, Abhishek Chand, Tuhin Batra & Akash | Winner RBI Policy Challenge 2016
Stabilizing inflation has been one of the most coveted goals of monetary policy all
around the world. Central banks around the world use various instruments to deal with this objective. Many theories have been presented to explain this phenomenon, most prominent being Philips curve citing a trade-off between inflation and unemployment. Other theories include structuralist approach and monetarist theory of inflation. We shall explain how this phenomenon affects the common man, reasons behind it and policy recommendations to address this issue.
Socialism for the Hedged
Anyone holding money assets in any form finds that it depreciates in value due to
inflation. Workers bringing home fixed wages find that their wages amount to lesser and lesser. The old generation finds that their decade old pensions now amount to very little.
The real return on government bonds reduces to zero. All fixed salaried professionals must now demand bonuses and raises to maintain their standard of living. While the poor and the middle class are unable to hedge themselves against price rise, the financially savvy can transform their wealth into mutual funds, equity, stocks, inflation- indexed bonds, gold, real estate and anything that protects their wealth from inflation.
Even if salaries and wages of the middle class rise eventually, they might find themselves in higher tax brackets and have to, unfairly, pay more tax. As rents go up
and cost of basic essentials go up, the lower middle class may even be flung temporarily into poverty. If the vast literature on poverty traps is accurate: such temporary poverty might become permanent.
Inflation redistributes income from fixed-income groups and creditors to flexible income groups and debtors. Since those who lose out outnumber those who stand to gain, inflation leads to distress and a collective feeling of suffocation. Persistently high food inflation in Egypt was one of the major causes of the outbreak of the revolution known as the “Arab Spring”. Inflation corrodes faith in the market economy and ameliorates demands for price and wage controls.
Distorted Signals and Risky Investments
An economy that does not have stable inflation will have proportionately higher variance in relative prices. Market signals will fail to carry the same informational content as before. Agents exert labor, time and sometimes even pay to compare and evaluate prices of different brands and substitutes. During unstable inflation and high relative price variability these „search‟ costs rise. For prices are changed far more often. Ill- informed buyers cease to distinguish between marginal and extra-marginal producers, and may choose to raise their reservation prices for products. This causes a fall in demand, as buyers become cautious. As extra-marginal firms having average costs higher than marginal firms begin to enter the market, we see a breakdown of the ability of the competitive market to keep only lowest-cost producers within the market.
The real damage that inflation can do is to economic growth. Inflation discourages household savings by chipping away at principals and interests thereby making it hard for investment to be financed. Investors are also discouraged from investing, for in the presence of rising input and output prices they are unable to gauge whether a fresh project is profitable or not. Technological upgrades and new capital arrive only hesitatingly. Inflation may stimulate capital flight, for investors would choose to park their funds in more stable assets abroad. Alternatively there is a shift in focus from production to speculation. The profits of arbitrage and speculation lure money away from productive activity leading to bubbles.
This effect is most evident in the case of large irreversible industrial projects. Specialized and expensive high-tech machinery can only be used in very narrow ways. Therefore, when market prices vary too much firms will be reluctant to make large scale and irreversible investments. They would rather invest in non-specialized capital like real estate that can be used in a variety of ways and disposed of easily. This could hamper the rise of developing economies like India.
“Inflation is everywhere, always a monetary phenomenon”
The important cause of inflation is a rise of the issued currency in circulation vis-à-vis
the natural level of production in the economy. In modern times, the central bank monopolizes the power to issue and regulate all legal means of exchange. It owns all
mints and issues legal tender. Therefore, it‟s monetary policy determines the level of
inflation in the long run.
Money does many things. It solves the problem of double co-incidence of wants. It tells us, immediately, what is our purchasing power worth. It allows us to postpone
purchases from the day of remuneration. But it does not determine the real pleasure of consuming commodities, the real hardship of labouring and the real risks of making an investment; all of those very considerations that individuals, households and firms base their economic activities on. Behind the voluminous and rapid movements of currency and demand deposits, the economy is nothing but a complex multi-lateral barter of goods and services. Since money is a veil over the real economy we reiterate Friedman‟s dictum, “Inflation is everywhere, always a monetary phenomenon”.
Inflation is generated whenever the growth of money supply outstrips the growth of
natural output. The monetarists therefore claim that the real antidote to inflation is a high growth of output (without easy money policies) alongside high interest rates (which prevent a faster growth of money supply).
Structural Constraints and Administered Prices
Notwithstanding the monetarist dictum, inflation in India is heavily influenced by supply bottlenecks in agriculture that are amplified due to price and wage controls. India‟s traditional agriculture, linked irrevocably to the monsoon, ensures that food supply is inelastic to price changes. Since the productivity of land is dependent on (a)
government intervention in irrigation, fertilizer subsidy, seed technology, land marketization and (b) natural factor like monsoons, floods and droughts, there is little
private farmers can do to increase production in the event that consumer demand rises.
Moreover, long cropping seasons limit the flexibility of output and only allow post-
production price variation as the tool for dealing with fluctuations in the demand for
agricultural produce.
Food inflation sharply reduces real wages in all sectors because food expenditures is
central to household expenditure. Disruptive fiscal policies such as MGNREGA and
MSP hasten the wage-price spiral. The former employs rural labor at 'support‟ wages
and the latter purchases crucial food commodities at ‟support‟ prices; in doing so, the
former acts as multiplier to wage inflation and the latter to food price inflation. They
introduce rigidities in the market, and ensure that wages and prices in agriculture are
downwards rigid.
These reasons ensure that rising output, income and consequently demand for agricultural produce leads to sharp food inflation. This leads to reduced real wages
across the economy, forcing workers to bid up nominal wages. General wage inflation
follows. Thereafter cost-push inflation punishes manufacturing and services, and wages being downwardly rigid leave no scope for a return to the “good old days”. The landless poor who are employed in the food industry spend almost all their incomes on food and are thus further punished for biding up their wages. Rural wage inflation is bolstered by and contributes to food inflation.
Some see inflation as the price of rapid modernization, where the focus of national
policy and resources are directed towards manufacturing and services and away from
traditional agriculture. Therefore they do not advocate inflation-targeting as it would
dampen growth prospects, and do not expect expectation anchoring to be of any use
when people already know that agriculture is the source of inflation. Over time they
expect India to resolve its agricultural bottlenecks via seed and crop technology, mechanized agriculture, inter-linked rivers, corporate farming, etc. As the share of food in Indians‟ consumption expenditures is expected to fall over time and rigidities in the rural wages would be smoothen out. Other are pessimistic. To them inflation is linked to political vote-banks and short-sighted electoral cycles. Inflation may be a permanent fixture in a populist democracy.
Coordination Problems
Even if markets are not rigid, governments can themselves impede the central bank‟s
attempt at inflation targeting. The Indian government does not pursue sound finance
and therefore RBI‟s public debt management responsibilities interfere with its pursuit of inflation targeting. Government‟s deficit financing forces RBI to issue more government bonds, putting a downward pressure on the bond interest rates. Lower bond interest rates, in turn, derail RBI‟s pursuit of inflation targeting.
Alternatively, since one fourth of the Indian government‟s expenditure account for
interest payments and so a rise in the policy rates could signal serious difficulties for the efficacy of fiscal policy. Government observes that it‟s past debt is rapidly liquidating in the presence of high inflation. Therefore they are inclined towards low interest rates and fresh loans and do not mind higher inflation.
Policy rate changes also suffer from transmission losses. Due to NPAs and other costs
involved, the influence of the RBI over commercial banks has waned. Since the repo
rates influence only a portion of commercial banks' costs, the RBI ceases to control "broad money". The shift from Base Rate to MCLR is a good step to improve transmission of policy rate, but more is needed.
Even if transmission losses and inter-governmental power struggles are resolved, for
people to expect that inflation will be what the Central Bank targets, the Central Bank
must have a credible reputation. The Indian public has doubts if RBI can actually achieve its targets as it has not been known to do so in the past. Therefore, they do not
internalize RBI‟s targets, and usually expect higher inflation than targeted. Higher inflation expectations imply lower production targets which leads, tragicomically, to
higher inflation; reaffirming the cycle of disbelief in the RBI.
Therefore before the monetary policy can actually set lower targets for inflation, it has to establish its own credibility with the Indian public. They should set targets which are achievable and go on to achieve them on a consistent basis to reach its goal of 4% (+/-2%) inflation. This will anchor inflation expectations of the public to its target. Only when this is done, can the RBI begin to reduce its target gently towards lower estimates without public expectations of inflation revolting against its estimate.
Policy Recommendations
a) Investment founded upon easy money policies is mal-investment, the grounds for its success rapidly evaporates once monetary stimulus is withdrawn and inflation is the residue. Counter cyclical monetary policy must understand its own limitations: one cannot fool all of the people all of the time.
b) Insulating the Central Bank from the election cycles and populism is imperative. Therefore reinstating a fixed 6-year term for its governor would be apt. Predictable rules must dominate discretionary monetary policy.
c) Greater transparency building measures, via Digital India and mass media. All the
inflation forecasting models of the RBI ought to publicly available, including key
internal documents revealing the inflation-averse nature of the RBI.
d) Amending constitution of RBI to exclude from its loss function considerations of
output & employment; it‟s lone macroeconomic responsibility must be price stability.
This can be done by introduction of a Public Debt Management Agency, reduction of
Statutory Liquidity Requirement and liberalizing of bond market.
e) Reinvigorated fiscal policy must commit to fiscal consolidation. This implies elimination of non-essential subsidies (e.g. fuel, oil) and plugging of leakages in essential subsidies (e.g. PDS, Pension).
f) Rerouting fiscal policy away from populism and towards investments in irrigation,
inter-linking of rivers, R&D and agriculture extension services, liberalization of
agricultural land, subsidization of corporate agriculture and large-scale mechanized
farming, delinking of agricultural supply curve from erratic monsoon and making it
sensitive to price changes.
g) Real time tracking of all relative price movements in the economy. Eliminating the
signal extraction problem that producers face will delink unanticipated money supply
shocks from real output in the short run.
h) Inflation-indexed bonds of varying maturity and interest rates to be offered to the
middle class and old. Financial literacy should be a part of NCERT course
curriculum alongside its workshops.
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