Low core inflation led the central bank to tighten too slowly
Better late than never, thinks the Reserve Bank of India. The country's central bank finally got aggressive in its fight against inflation this month, raising interest rates by half a percentage point. For the last 15 months, year-on-year wholesale price inflation has stayed above 8%, sometimes entering double digits. Figures released this week show April inflation continuing the trend at 8.7%. RBI Governor Duvvuri Subbarao has been reacting slowly to the buildup of these inflationary pressures. So, in and of itself, this month's move is praiseworthy. But if seen along with the RBI's laggard behavior over the past year, Mr. Subbarao continues to betray his weakness. At fault is his attachment to the concept of core inflation. He believes changes in the prices of non-food, non-fuel items are what really matter, since inflation caused by food and fuel is beyond his control. In the RBI's defense, some of India's inflation is indeed beyond the control of its central bankers. Above all, the U.S. Federal Reserve's weak-dollar policy plays havoc with global commodities and capital flows, from which an open Indian economy isn't insulated. But it won't do to blame the RBI's problems on Ben Bernanke: After loosening liquidity in the wake of the 2008 panic, Mr. Subbarao has taken his sweet time to close the monetary spigots. Though the price level started accelerating in late 2009, the RBI only raised rates beginning March 2010, and then only in baby steps of a quarter percentage point on eight occasions until this month. Factoring in the latest hike, the central bank's benchmark rate, at which it lends to commercial banks, now stands at 7.25%. That means that with headline inflation averaging around 9%, this rate has been below zero in real terms for 15 months—and perhaps longer. Yet the RBI insisted that most of the headline inflation in the past year has been driven by exogenous "supply shocks." Left to the mercy of global oil at $100 a barrel, along with a 2009 drought that battered food supplies, Mr. Subbarao argued that altering interest rates won't accomplish much. Hence, he preferred to look at core inflation, which remained subdued for most of 2009 and 2010. Yes, a central bank has little power over a weather shock that changes the price of, say, rice relative to general prices. But a regular supply shock doesn't last 15 months. Nor does it change the general price level. What changes general prices is money. If money were tight, households would reduce expenditure of other items when they were forced to pay for more expensive rice, thereby keeping the general price level constant. That was a clear lesson of the 1970s, when core inflation became an intellectual refuge for hesitant central bankers. Peddling this concept, then-Fed Chairman Arthur Burns targeted core consumer prices. So, after the oil shock of 1973, Fed accommodation pushed inflation up the next year. In a recent paper, Vivek Moorthy and Shrikant Kolhar at the Indian Institute of Management in Bangalore show what the Bundesbank instead did. The West German central bank tightened in 1973, forcing headline inflation down. Mr. Subbarao has followed the Burns approach here, and stoked more inflation by tightening slowly. He seems to think that stripping away erratic supply factors is the best measure of real price pressures and expectations in the economy. But that misjudges how ordinary people react to expensive food and fuel. These apparent "non-core" items affect core expectations—perhaps more in a developing country where these items make up the lion's share of household expenditure. Workers will expect generalized inflation because the food on their dinner plates becomes more expensive. They will demand higher wages and, in turn, producers will demand higher prices. So it was only a matter of time before expensive food and fuel spilled over into other prices. The RBI's measure of core inflation has been blinking red since December, edging up 7.3% year-on-year in March and 6.3% in April. That was Mr. Subbarao's motivation for his larger-than-usual hike this month. Yet, because he has been slow to act, he now has to contend with people's expectations getting out of control. The RBI's survey on inflation expectations published last month show that people expect up to 13.1% inflation by the end of this year. These altered expectations filter down to economic decision making. Despite the promise of 8.6% growth for India's economy, investors are wary, since capital earns low real returns. Inflation paralyzed the country's financial system in December: Indians began pulling money out of low-interest-bearing bank deposits, causing a temporary, yet powerful, liquidity squeeze. To repair this short-term damage, the RBI this month raised the rate on savings accounts—a rate the government still regulates. The best way now, though, for Mr. Subbarao to repair long-term inflation expectations, as well as the credibility of his central bank, is by staying clear of the very concept of core inflation. The RBI has to keep tightening, no matter the next oil or food shock. The prices of rice and gasoline, and perhaps other commodities and assets too, matter no less for economic agents than the prices of TVs and iPhones. Self-imposed blinders like core inflation will only hide this core truth from view.
