MPC's Actions Have Little Impact On Inflation; We Must Focus On Growth

In the next two days, we will know whether the Monetary Policy Committee (MPC) is going to focus on inflation or growth.

Most analysts are betting that there may be one more rate hike of 25 basis points, before it calls a pause. 

The MPC would do well to call a pause right away, for growth is clearly going to be the big challenge going forward. Reason: the global climate for growth is weakening substantially.

Immediate fears of a global banking collapse were staved off by timely action from the US Fed (Silicon Valley and Signature Bank) and the Swiss National Bank (which allowed UBS to take over Credit Suisse), but worries about other banks remain.

In the last week of March, Deutsche Bank shares crashed over fears of banking contagion. Even in the US, fears of another regional bank crashing have not disappeared.

According to one report, vulnerable banks have lost more than $1 trillion in deposits over the last one year, while another says that the quantum of uninsured deposits is equally large at $1 trillion.

Clearly, the banking crisis is not over, and, in the meanwhile, OPEC has just decided to cut production, raising oil prices sharply just when fears of another recession are mounting.

This means India, which imports 85 per cent of its oil requirements, will not see any reduction in import costs for a while, impacting growth. Add the prospect of a weaker monsoon this year, and it should be clear that growth is going to be the real challenge, even though inflation will remain elevated.

It is a difficult choice and in a country like India, unless inflation is closer to double digits and growth remains above seven per cent, the tilt must be in favour of growth. Without growth, it is the poor who will be worst impacted.

There are, however, two other reasons why the MPC must not be given too much importance. It does not have the tools to fight inflation without damaging growth.

First, given the growing complexity of the modern economy, and given the fresh economic and political shocks that may still be in store, the assumption that monetary policy alone can deliver lower inflation, and that too to the exclusion of other economic objectives, is seriously flawed.

As Swaminathan Aiyar writes in The Economic Times: “My conclusion is not that RBI has failed to check inflation. Rather, events show that the entire theoretical basis of inflation targeting is dubious. Central banks have limited tools, whose impact suffers from long, variable lags. Nobody knows if central banks have the right tools and how well those work. Often tight money seems to affect GDP growth more than inflation”. 

Exactly. If we are going to keep raising rates by focusing on inflation when we can’t even be sure of ensuring that outcome, we are surely going to cripple growth when we need it the most.

Second, there is no evidence whatsoever that ‘core inflation’, that part of inflation that excludes transitory factors like food or fuel price trends, has ever been tamed, either before the MPC was set up, or after.

A research paper by Pulapre Balakrishnan and M Parameswaran, in fact, makes the claim that the moderation in inflation after 2014 had nothing to do with the MPC’s own decisions, which has been credited with “anchoring” inflationary expectations around the four per cent middle rate.

The paper, titled What lowered inflation in India: monetary policy or commodity prices? debunks the claim that monetary policy actions had anything to do with the lower trajectory of inflation after 2014, and especially after 2016, after the MPC was set up. Core inflation has never fallen below four per cent since 2012.

The authors say that the fall in retail inflation between 2014 and 2022 has been (wrongly) “attributed to the adoption of inflation targeting by the central bank, the Reserve Bank of India in 2016. In particular, it has been asserted that the lower inflation reflects the anchoring of expectations….An econometric investigation indicates that there is no basis to the claim that inflation has been lowered due to the anchoring of expectations. On the other hand, we are able to account for the trajectory of inflation in India after 2016 in terms of an alternative explanation of inflation, namely the structuralist.”

They add: “On the basis of the econometric evidence for the two models of inflation in the Indian context, it may be surmised that the stable inflation since the adoption of inflation targeting in 2016 owes to the behaviour of the relative price of agricultural goods and the price of imported oil.”

This should have been obvious, for till 2022, both agricultural prices and fuel prices were stable, or weakening in relative terms. 

The conclusions the government and the Reserve Bank of India (RBI) should draw from this are two-fold:

One, the MPC is not central to the taming of inflation. Fiscal factors, commodity prices and indirect taxation make a much bigger difference.

Two, the focus of the RBI should be growth first, inflation next, and that too only if inflation looks likely to shoot towards double-digits, as was the case during UPA rule.

Right now, elevated inflation is something we can live with. Slower growth is the worse of two evils.