Inflation in India cannot be simply described as ‘cost-push’; Abundance of liquidity has been an important factor
Inflation in India cannot be simply described as ‘cost-push’; Abundance of liquidity has been an important factor
Recent Actions of Reserve Bank of India (RBI) To increase the repo rate by 40 basis points and Cash Reserve Ratio (CRR) by 50 basis points is a recognition of the dire situation regarding inflation in our country and the resolve to tackle inflation. Inflation has assumed an alarming proportion in almost all countries. The situation is worst in the United States where consumer price inflation (in March 2022) stood at 8.56%, a level not reached for several decades. The Consumer Price Index (CPI) inflation in India (as in March 2022) stood at 6.95%. It is expected to increase further in April. India’s CPI inflation is fluctuating around higher levels. In early October 2020, it had reached a peak of 7.61%. It remained at a high of over 6% since April 2020. It decreased after December 2020, but has started increasing significantly from January 2022.
On the other hand, Wholesale Price Index (WPI) inflation remained in double digits since April 2021. The GDP implied price deflation-based inflation rate for 2021-22 is 9.6%.
impact on production
Even though RBI’s mandate is with respect to CPI inflation, policy makers cannot ignore the behavior of other price indices. In the 2008–09 crisis, the central banks of developed countries, particularly the Fed, were blamed for ignoring the sharp rise in asset prices, even though CPI inflation was modest.
After the advent of COVID-19, the major concern of the policy makers across the world was to revive the demand. This was sought to be achieved by increasing government spending. This is the standard Keynesian recipe. The severe lockdown imposed to contain the spread of COVID-19 restricted the mobility of people, goods and services.
Thus, expansion in government expenditure did not lead to an immediate increase in production in countries where lockdowns were taken seriously. India falls in this category. As VKRV Rao pointed out in the 1950s, the Keynesian multiplier did not work when there was a supply crunch in developing countries. That is why he argued that in such countries the multiplier does not operate in real terms but in nominal terms. Something similar has happened in the present case where the shortfall in supply is due to non-mobility of the factors of production.
inflation issue
Nevertheless, the recipe for increased government spending still stands valid in the present circumstances. Perhaps the increase in production could be accompanied by a lag and also with the easing of restrictions. Initially, the focus of monetary policy in India has been on keeping the interest rate low and increasing the availability of liquidity through various channels, some of which have been introduced recently. However, the rate of growth of the currency was less than the rate of growth in the reserve currency. This is due to low credit growth which also depends on business sentiment and investment climate. Thus the money multiplier is lower than normal. The government’s borrowing programme, which was large, ran smoothly due to abundant liquidity.
When the economy picked up in 2021-22, inflation also became an issue. As mentioned in the beginning, this is a worldwide phenomenon. In the US, the explanation has been fairly simple. The Fed’s balance sheet has exploded. The Fed’s net assets (less certain commodities) stood at $4.17 trillion on January 1, 2020, and $8.96 trillion in April 2022. This broad expansion in assets is the result of quantitative easing which is essentially the liquidity support provided by the Fed.
editorial | Inevitable hike: On RBI interest rate hike
The Fed chairman has made strong statements expressing the need to reduce the size of assets. The Fed is planning to reduce its balance sheet by $95 billion a month. It had hiked the policy rate by 50 basis points a few days back. Monetary policy has also changed in India. The latest monetary policy reiterates the stance to “remain accommodative with focus on return of adjustments” to ensure that inflation remains within target going forward, supporting growth. Inflation will not come down without efforts to infuse liquidity.
I go back to the point I’ve been making several times recently. When discussing inflation, analysts, including policymakers, focus almost exclusively on rising prices of individual commodities such as crude oil as the primary cause of inflation. The Russo-Ukraine War is cited as the primary cause. True, in many situations, including the current situation, they can be triggered. Supply disruptions due to domestic or external factors can explain the behavior of individual prices but not the general price level, which is what inflation is about. Given the budget constraints, only relative prices will be adjusted.
Besides the fact that any cost-push increase in a commodity can be generalised, it is the adjustments that occur at the macro level that become important. Not long ago, Friedman said, “It is true that an upward push in wages produced inflation, not because it was necessarily inflation, but because it was the mechanism that forced an increase in the money stock.” Did”. Thus, it is the adjustment in the macro level of liquidity that keeps inflation in check.
inflation and growth
The potential trade-off between inflation and growth has a long history in the economic literature. Theoretical and empirical analysis of Philip’s curve has been done. Tobin called Philip’s curve the ‘brutal dilemma’ because it suggested that full employment was not conducive to price stability. The important question that flows from these discussions on trade-offs is whether cost-push factors can themselves generate inflation. Tobin stated at one point that inflation is ‘neither demand-attraction nor cost-push or rather it is both’, even though he did not agree with Friedman’s extreme position that there would be no net cost-push inflation. .
Read also | ICICI, BoB, BoI, Central Bank revise lending rates after RBI hikes repo rate
In the current situation, it is sometimes argued that inflation will come down if some of the increase in crude oil prices is absorbed by the government. There may be a case for reducing the duty on petroleum products, simply because a section of the population should not bear the excessive burden. The same idea applies to food prices. But to think that it is a magic wand to avoid inflation is wrong. If the additional burden (through loss of revenue) to be borne by the government is not reimbursed by expenditure, the overall deficit will increase. The lending program will increase and additional liquidity support may be required.
concomitant decision
Commenting on the hike in repo rate and increase in CRR, some have commented that it is a double whammy. No, these are concomitant decisions. Central banks cannot dictate interest rates. To check interest rate hike, appropriate action should be taken to infuse liquidity. This will happen as the CRR increases. In the absence of an increase in CRR, open market operations would suck up liquidity. As RBI Governor Shaktikanta Das said in his statement, “Liquidity positions need to be revised in line with policy action and stance to ensure their full and efficient transmission to the rest of the economy.”
Inflation in India cannot be simply described as ‘cost-push’. Abundance of liquidity has been an important factor. The April monetary policy statement spoke of a liquidity overhang of the order of ₹8.5 lakh crore. Beyond a point, inflation itself may hinder growth. Negative real rates of interest on savings are not conducive to growth. Liquidity action with concomitant increase in interest rate on deposits and loans is very much needed if we are to control inflation.
C. Rangarajan is the former Chairman of the Economic Advisory Council to the Prime Minister and the former Governor of the Reserve Bank of India.