Opinion Why policy needs to square with reality

The inflation response? Single digit WPI inflation was reached in June 1995,and by January 1996,inflation was down to only 5 per cent. For the next 11 years,the average rate of WPI inflation remained at 5 per cent! This sharp slowdown in inflation,some believe,was due to the Volcker-like response of India’s RBI. And this Indian experience is now being cited,quoted,and invoked,to justify the remarkably aggressive past rate hikes of the RBI — and recommendations for the continuation of the same.

We should learn from history; if we do not,what else are we going to learn from? But there is a burden on learning,especially when it means that policy recommendations can affect the course of an economy,and millions of jobs are dependent on the “right” RBI policy. Inflation,and lack of growth,also hurts the poor the most. It is nobody’s case that high inflation should be allowed to persist; and it is everybody’s case (or should be) that the instruments used to reduce inflation be appropriate,that is,the policy should be effective in achieving its goals.

So was a policy that would embarrass most hawks successful in reducing India’s inflation — or was this policy fortuitously correlated with a decline in international inflation? Between 1993 and 1997,median WPI inflation in developing countries fell by 2.8 percentage points,from 7.0 to 4.2 per cent. The fall in Indian WPI inflation — 2.1 percentage points from 7.7 per cent in 1993 to 4.6 per cent in 1997. In 1991,the start of the short high inflation episode,Indian WPI inflation was 13.7 per cent; emerging markets WPI inflation in the same year,a near-identical 12.1 per cent.

There is no evidence — zero — to link the decline in India’s inflation rate post-1996 to Indian monetary policy,while there is a lot to link the decline in India’s GDP growth rate to this very same policy. GDP growth in India,after averaging above 7 per cent for three consecutive years,1994 to 1996,collapsed to an average of 5.1 per cent rate over the next six years,1997 to 2002. We all know about the great Indian miracle growth from 2003 onwards. What some of us may not know,and a few of us do not want to realise,is that the take-off in Indian growth took place because of a large 450 basis point decline in nominal and real interest rates during 1999 to 2003; and the take-down in growth took place because of a large increase in RBI’s monetary tightness in the mid-1990s.

History suggests that it is time for the RBI to be independent and break the umbilical cord with 1990s,and UPA 1 and UPA 2’s monetarism. While it is contemplating this momentous decision,it should also take time out to study the chart. This chart documents the evolution of two inflation indices — administered food inflation and CPI inflation. The former is the inflation in procurement prices for agricultural crops. These prices are set by the government and are the prices at which the government purchases crops from the farmers. These purchase prices are food inflation! A non-recognition of this simple fact has left several inflation hawks (including the RBI?) to conclude that an increase in repo rates will help reduce food inflation. Even if the RBI were to increase such rates to 9 or 15 or 30 per cent,it will have zero effect on half the consumption basket that is food. For sure,the economy will collapse with such rate hikes — as it did mid-’90s onwards,and possibly led to the crashing decline of the Congress in the 1996 national election.

The graph illustrates the various turning points in Indian inflation for the last 30 years. Note the close correspondence — and especially note the economically criminal vote-getting policy of the Congress after it came to power in May 2004. Starting in 2006,procurement prices literally exploded,with an 18 per cent increase in 2008 alone. Between 2006 and 2009,the relative price of food increased by a record 33 per cent. The normal pattern is for the relative price to move in a plus/minus 5 per cent range. It is this procurement price increase that has led to high and sticky inflation in India. And it is this inflation that the quixotic RBI wants to reduce by raising repo rates. Never in history has a more inappropriate instrument been used. And sometime,the RBI,the PMO,and the Congress party will have to answer to this uncomfortable reality.

If procurement price inflation declines,overall inflation should approach the historic and tolerable 5 per cent level. If the Congress party were to reduce the price increase in procurement prices (and it appears that it is doing that),food inflation will come down and so will overall inflation — and India might finally be able to progress along its potential growth path of 8-9 per cent GDP growth.

The writer is chairman of Oxus Investments,an emerging market advisory and fund management firm