As the Reserve Bank of India (RBI) prepares for the presentation of its monetary policy review on July 29, its foremost thought should be on the deteriorating price situation compounded by signs of deceleration in economic growth. Earlier, the RBI predicted that the inflation rate would be 5.5 per cent for the year.
The Index Number of Wholesale Prices stood at 226.0 as on March 29, 2008. Factoring in an inflation rate of 5.5 per cent over the year, it will likely be 238.43, at the end of 2008-09.
As on July 5, it had already reached that level. It is unrealistic to expect that it will remain there for another nine months to give us a point-to-point annual inflation rate of 5.5 per cent. The situation is murky, complicated as it is by many factors, domestic and international. It would be better for the RBI not to indicate its estimate of the likely inflation rate but only reiterate its medium-term target, as announced in the Annual Policy Statement. It can have its estimate for internal purposes, without making it public.
Central banks of developed countries do not make any forecasts of inflation; they know it is as undesirable as talking about the future course of currency values. While this is understandable in countries that have adopted inflation-targeting, central banks even in other countries, such as the US, talk in general terms about inflation scenario without specifying the expected rate.
Among the causes of the current inflation, one mentioned frequently is high international prices of commodities. It is now reported to be further aggravated by the rupee’s depreciation. This needs to be analysed in greater depth. We do not have the latest information on the currency composition of import invoices. But trends indicate a decline in the share of dollar invoicing in the total value of imports over the years. It may be around two-thirds of total value.
Since the values of important international currencies show divergent trends vis-À-vis the rupee, one needs to isolate the influence of dollar appreciation on import prices.
Second, oil, an important dollar-denominated import, accounts for about one-third of the total. The pass-through of international oil prices has been only partial. Oil is, of course, all-pervading in its influence on inter-industry transaction (or input-output) tables of the economy. We need to know how much the limited pass-through of high oil prices has contributed to inflation.
In the distant past, the Econometric Division of the RBI did some pioneering work in tracing the sources of inflation. A macro-model for the economy, published in Reserve Bank of India Occasional Papers of December 1984, estimated the contribution of agricultural and non-agricultural production, administered prices and import prices to inflation between 1975-76 and 1982-83, and from 1979-80 to 1982-83.
The article elicited considerable interest when it was presented at the time at a seminar organised by the Institute of Economic Growth in Delhi, and was discussed in depth. One does not know whether similar research has been done in the RBI or other institutions since then and, if so, whether it has influenced policy-making. But it is obvious that identifying and isolating the causative factors for inflation is the first step towards taking remedial action.
In a speech he made on “Exchange Rate Pass-Through and Monetary Policy” at the Norges Bank Conference on Monetary Policy, Oslo, Norway, on March 7, 2008, Governor Mishkin of the US Federal Reserve presented an in-depth analysis of the declining influence of currency depreciation on consumer inflation.
Summarising the lessons from the empirical evidence on exchange rate pass-through he said that sizeable depreciations of the nominal exchange rate exert fairly small effects on consumer prices across a wide set of industrial countries, and these effects have declined over the past two decades.
The pass-through from exchange rates to import prices has been low and has declined markedly over this period. Specifically, he pointed out the weak correlation between exchange rate depreciation and inflation, even in highly open economies.
This is because, in recent years, expectations of inflation have become much more solidly anchored. Traditional monetary theorists were correct in emphasising that exchange rate depreciation and inflation were likely to be closely linked under an unstable monetary policy environment without a nominal anchor.
Thus, a stable monetary policy — supported by an institutional framework that allows the central bank to pursue a policy independent of fiscal considerations and political pressures — effectively removes an important potential source of high pass-through of exchange rate changes to consumer prices.
Appropriately, the RBI Governor, Dr Y. V. Reddy, has frequently emphasised the need for anchoring inflation expectations at a low level. It requires a stable monetary policy environment. The RBI’s hands have been strengthened by the statutory prohibition of its playing the role of an underwriter for government securities.
In the context of growth in money supply above its target and, more so in reserve money, markets expect the RBI to raise the Cash Reserve Ratio (CRR) and/or the Repo Rate by a further 25 basis points, at the minimum. That the monetary position is already tight is clear from several factors.
The actual CRR for the banking system stood at 8.72 per cent as on July 4, 2008, against the required ratio of 8.25 per cent. Generally, the system keeps an extra 1 per cent to settle inter-bank transactions. This was not the case in the latest instance.
The CRR was raised by two instalments of 25 basis points each, as on July 5 and July 19. The tight reserve position has been reflected by the trends in the rising call money rates and the large amounts of repo transactions done with the RBI. Many banks have announced increases in deposit rates, particularly in the short to medium-term maturity buckets. The money multiplier is not instantaneous. It takes its own time to work out its full effects on the economy. The RBI should wait for some time before further tightening.
The need is for soft-landing of the economy. The prices of basic commodities like food-grains and edible oils need to be tackled from the supply side.
No doubt, there is demand-side pressure emanating from such initiatives as the Rural Employment Guarantee Scheme, which was extended at one go for the whole country by the government on political considerations, without reckoning with its impact on aggregate demand and prices. Now it cannot be undone.
The tightness in policy has been somewhat compromised by the central bank’s decision to buy oil bonds in exchange for forex. Although the monetary impact is neutral, one may argue that the tightness would have been reinforced by making the oil companies resort to the banking system for funds. They could not easily sell bonds to banks because they do not qualify for SLR and the latter demand high discounts.
The RBI should release data periodically on its oil bond transactions in the interests of transparency. Instead of raising the CRR or Repo Rate it may withdraw the scheme for the purchase of oil bonds and declare them to be SLR-eligible.
For prudential reasons, banks would then prefer to buy them rather than enhance the credit limits reported to be demanded by oil companies.
The RBI has asked banks to review by May 15 advances against selected commodities to know their role in speculative hoarding. It is time the findings are made public.
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