Monetary policy: Implications for Common Person - S. S. TARAPORE

It is essential that the Common Person has some understanding of macroeconomic policies. The central objective of this column would be to present, free from jargon, the essential features of these policies.  On January 25, 2011, the Reserve Bank of India ( RBI) undertook its third quarter review for 2010- 11. In a global economy, which is still in the process of recovering its momentum after the financial crisis of 2007/ 8, India has attained a high growth rate in 2010- 11 of at least 8.5 per cent - the second highest in the world. The central anxiety for the Common Person in India is inflation. The authorities use the Wholesale Price Index (WPI) to measure inflation, which, on a year on year basis as of December 2010, shows an increase of 8.4 per cent as against the RBI’s comfort zone of 5 per cent. The official projection is that at the end of March 2011, the inflation would be 7.0 per cent, as against the earlier projection of 5.5 per cent inflation. Both the government and RBI seem to argue that essentially supply side factors account for inflation. One can understand a supply side generated inflation in one or two commodities but generalized inflation, with which the Common Person is afflicted, cannot be considered as supply side inflation. It is no solace to the Common Person to be told that the inflation is “ structural” While it raises heckles with the majority of policy makers in India, the harsh reality of generalized inflation is that such inflation is a monetary phenomenon; although monetary policy cannot tackle inflation exclusively on its own, monetary policy has a major responsibility in tackling inflation. The Common Person would accept an 8.5 per cent inflation, provided it was a reasonably accurate assessment of the “ true” rate of inflation. It is demeaning to tell the Common Person that the “ true “ rate of inflation is only 8.5 per cent, as the inflation rate in the market place is significantly higher than what the index shows. There are many deficiencies in the WPI. First, food articles and products account for only 24 per cent of the weightage in the WPI, while in the family budget of the Common Person, food accounts for over 50 per cent of total expenditure. Secondly, when the authorities claim that inflation is coming down, what they mean is that the rate of inflation is coming down and not the level. Thus the cruel burden on the Common Person is not eased. Thirdly, the world over, it is not the WPI but the Consumer Price Index ( CPI) which is used as an indicator of inflation. The excuse for not giving primacy to the CPI in India is that there are multiple CPI indicators and that the CPI is available only with a lag. Surely, in a country which claims to have the best statisticians in the world, it cannot be beyond our skills to quickly produce a representative CPI. Fourthly, a very sensitive issue with the authorities is that none of the indicators of inflation reflect the “ true” inflation at the grassroots level. The Dharma of the RBI is inflation control and it cannot put growth as a priority over inflation control. Tilting the balance in favour of growth as indeed the authorities are doing at the present time does not reflect a just society which is sensitive to the fact that there are vast tracts of poverty in India. Ideally, one hopes for a higher growth with low inflation but such a Paradise just does not exist and soft policy options carry with them the danger of inflation getting deeply entrenched.  Now what has been the policy response of the RBI on January 25, 2011? The RBI raised the repo rate i. e. the rate at which the RBI lends to banks against government securities from 6.25 per cent to 6.50 per cent. At this rate of interest the banks find it attractive to borrow from the RBI rather than raise deposits. The credit growth has outstripped the deposit growth the incremental credit- deposit ratio in December 2010 was over 100 per cent; this is unsustainable as banks have to maintain cash with the RBI and also invest in government securities. Thus, there is a large gap which is filled by borrowing from the RBI. The more the RBI lends to banks at cheap rates of interest the more the banks lend and there is a vicious circle of continuing tight liquidity. The RBI has also extended the period for exceptional access provided to banks. This means that monetary policy continues to be very loose. Given the high inflation rate, the appropriate response would be to reduce access to the RBI and to sharply raise the cost of RBI financing. Quite clearly, the RBI seems to have given up its sacrosanct Dharma it is not willing to mortally wound the dragon of inflation, lest growth get affected. In the upshot, what can the Common Person expect? Deposit rates will continue to be low in the context of the high inflation and the banks will make only token attempts to slow down lending. Any abatement of inflation will essentially be a statistical phenomenon. The underlying strong inflationary pressures would continue and may even get aggravated. To the extent the Common Person saves in the form of bank deposits, it is best to restrict placements to maturities up to one year. If the Common Person is a borrower, it would be best to undertake the borrowing quickly.  The heart- rending message for the Common Person is to get ready for a bumpy ride with accelerated inflation. There is nothing in the monetary policy which would convince the Common Person that the situation would improve in the ensuing few months.