Why RBI must heed inflation

Indian Express, March 29, 2022

The Reserve Bank of India is an inflation targeting central bank. It is legally mandated to keep inflation in check. Yet the RBI has persisted with its easy monetary policy, even as inflation pressures have increased. We need to understand why, and what could be the repercussions.

Let's first ask, is inflation a problem in India? Indeed, it is. For most of the past two years, CPI (consumer price index) inflation has been hovering close to the 6 percent upper threshold of the RBI’s target band. Inflation averaged 6.1 percent during the pandemic period (April 2020 to June 2021), despite a massive collapse in aggregate demand. It then dipped somewhat as food prices eased, but underlying inflation (i.e., core inflation, excluding food and fuel items) has remained around 6 percent for the last twelve months. Then in January 2022, as food prices recovered, headline inflation once again crossed the upper threshold of the RBI's inflation targeting band.

Inflationary pressures do not seem to be diminishing either. Instead, they continue to build up. The standard measure of inflation "in the pipeline" is WPI (wholesale price index) inflation, since price increases at the wholesale level tend to translate into retail inflation in due course. And the WPI is sounding a loud alarm. Between April 2021 and February 2022, WPI inflation averaged 12.7 percent, the highest in more than a decade.

The problems do not stop there. Russia’s invasion of Ukraine has resulted in a sharp increase in global commodity prices, including prices of crude oil, edible oils, and fertilisers. At the same time, a resurgence of the Covid-19 pandemic in mainland China and Hong Kong has led to shutdowns that will further constrain supplies of raw materials. Even if the war and the pandemic in China both subside soon, their effects will not. Sanctions on Russia are likely to remain for some time, while it will take a while for China to clear the backlog of orders that the shutdowns have caused.

Indian firms are already adapting to this situation, passing on the commodity price increases to retail prices. We have reports of double-digit increases in the prices of consumer goods (FMCG) as well as in the real estate sector. Even though the government continues to suppress domestic pump prices, prices of petrol, diesel and cooking gas have gone up in major cities.

Standard economics gives us a guide for how central banks should react in a situation like this. It says that monetary policy should accommodate the first round of commodity price increase, but only under certain conditions, notably that inflation is initially on target, and expectations are firmly anchored. But neither condition holds at present. Inflation is already too high, and so are expectations. As of January 2022, 68 percent of households surveyed by the RBI expected prices in the 1-year ahead period to increase more than the current rate, up from 63 percent one year ago; more than 57 percent households expected cost of services in the 1-year ahead period to increase more than the current levels, up from 51 percent one year ago.

In some quarters, an argument is nonetheless being made that monetary policy should not be tightened when inflation is driven by supply-side factors, as it can adversely impact growth. This is fallacious; it has things exactly backward. When there are supply constraints, using easy monetary policy to boost demand is not going to boost output. It will only create a situation of excess demand, pushing up prices even further. And if firms are expecting high inflation, this will send things into a vicious spiral, as they will increase their prices even more in advance of any input price pressures.

Surely the RBI is aware of all of this. So why is it still not acting on it? To answer this let’s take a step back and look at what is happening globally.

The RBI is not the only central bank that is not reacting to inflation. In the US, the Federal Reserve has been slow to raise rates even as inflation has reached a four-decade high. The ECB in Europe has been even slower to react. The problem seems to be that governments all over the world are worried about growth. They are hoping that central banks can somehow solve this problem, since government debts are at exceptionally high levels. Until governments accept that reviving growth is their responsibility, not that of the central banks, and especially not when inflationary pressures are on the rise, central banks will not be able to focus on inflation.

In India, monetary policy also suffers from a strong fiscal dominance. As a result, not only is the RBI expected to support growth, it is also expected to keep the government’s borrowing costs in check, which is in direct conflict with its inflation targeting objective.

What are the repercussions of the RBI ignoring inflationary pressures? A decade ago, we were in a similar situation where inflation had started increasing but the RBI delayed its response because it was focusing on growth. When inflation subsequently took off, it reached double digits and the RBI had to raise interest rates aggressively to bring it down. That was a very painful adjustment. We do not need a repeat of that episode now. In other words, we need to recognise that high inflation is the real threat to growth, not a prudent monetary policy tightening.

In addition, if the RBI does allow inflation to take off, there will be long-lasting repercussions for the credibility of the RBI. Inflation control requires anchored inflation expectations. But if the public see the RBI consistently ignoring inflation, expectations can rapidly get unanchored and then it becomes very costly to bring inflation down.

In summary, inflation is best addressed by the central bank using monetary policy, not by the government adjusting taxes. The RBI needs to urgently revisit its inflation forecast and its monetary policy stance in order to avoid potentially painful adjustments down the road.

Monetary policy: Losing clarity on instruments and goals

(with Harsh Vardhan), Times of India, February 15, 2022

After the Union Budget, economists as well as financial market participants eagerly waited for the Reserve Bank of India to announce its strategy for the coming fiscal year. On February 10, the Governor and the Monetary Policy Committee (MPC) duly outlined their approach. These statements, however, only raised more questions than they answered.

Before the pandemic began, monetary policy was straightforward. The RBI’s objective was clear, as it had a legal mandate under the Inflation Targeting regime of ensuring that consumer price index inflation remained within a 2-6 percent band. Accordingly, at each Policy Review the MPC would set the repo rate at the level it thought would be sufficient to achieve this target. All other interest rates were sideshows, because they were automatically adjusted whenever the repo rate was changed.

Since the pandemic however, the RBI’s operational strategy has changed dramatically. The repo rate has ceased to be the policy instrument, being replaced by the reverse repo rate, i.e. the rate at which banks park their short-term liquidity with the RBI. At the same time, other rates have become detached from the policy rate. So, there is no longer one clear measure of the policy stance, making it difficult to understand what strategy the RBI is pursuing.

After the February 10th review, this confusion has only deepened. Here we highlight four areas of particular ambiguity.

First, it is unclear whether the RBI is maintaining its stance – or tightening it. The official settings have not been changed. But at the same time the Governor emphasized that the effective reverse repo rate has increased from 3.37 percent in August 2021 to 3.87 percent in February 2022, suggesting that behind the scenes policy is being tightened.

How is the RBI doing this? Over the past few months, it has introduced a new facility, the variable reverse repo rate (VRRR) auction. The RBI is now absorbing liquidity under two facilities at two different prices – the reverse repo, with a rate of 3.35 percent, and the VRRR, with a rate of 3.87 percent. Markets expected this anomalous situation to be regularised at the Policy Review, through an increase in the reverse repo rate. But this did not happen. So markets are now confused: what is the RBI’s policy rate?

Second, markets are confused about the RBI’s liquidity stance. During the pandemic period, the RBI injected massive amounts of liquidity into the banking system by buying government bonds, and then stopped as the situation improved. Presumably, the next step would be to wind back the excess liquidity it had created. That would require selling some of the bonds it has accumulated, putting upward pressure on the rates on government securities. Alternatively, it might want to contain G-Sec rates to support the government’s large borrowing programme, but this would entail buying more government bonds, adding to the excess liquidity and risking higher inflation. So, which way is the RBI planning to go? The RBI did not say.

Third, the RBI tried to shed some light on its stance by stating that it will remain accommodative. But this statement has been stripped of much of its meaning. The RBI’s stance has remained “accommodative” across the last 12 meetings, even as it has gone from reducing the reverse repo rate to raising the effective rate, and from injecting liquidity to containing liquidity. So, what precisely does "accommodative" mean?

Finally, the RBI has indicated that it is comfortable with the inflation outlook, predicting that CPI inflation will be 4.5 percent in 2022-23. But can it really be that comfortable? Developed countries are experiencing their highest inflation in four decades, with inflation in the US now running at 7.5 percent. As a result, India faces the risk of importing high inflation. In particular, since the last time retail oil prices were raised, global crude oil prices have increased from USD 75 to USD 90 per barrel. If this increase is passed on to consumers, inflation is bound to rise.

Meanwhile, the Union Budget has announced that it plans to stimulate aggregate demand by increasing capital expenditure, at a time when private sector activity has started to revive. But if the pandemic continues to restrain supply, a significant increase in aggregate demand will only intensify inflationary pressures.

So, there is a real risk that inflation will be far higher than 4.5 percent. If so, what will the RBI do? Again, the market has no idea.

The end result is considerable confusion. It is unclear whether the RBI is committed to low inflation – or to coming up with highly dovish forecasts in order to support the government’s stimulative policy. Nor is it clear what the instruments of monetary policy are, as the repo rate and now the reverse repo rate have lost relevance. So what is the policy rate, and where is it heading? No one knows.

The Governor quoted a line from the late Ms Lata Mangeshkar’s famous song "Aaj Phir Jeene Ki Tamanna Hai". It is wise for us to remember the second line of the song “Aaj Phir Marne Ka Iraada Hai” and note that Tamanna means desire and Iraada means intention!

Budget 2022-23: Hits and misses

Budget 2022-23: Hits and misses, Ideas for India, February 14, 2022.

RBI’s dilemma: Let prices rise or interest rates?

Times of India, February 8, 2022

One of the striking features of the Union Budget was the high borrowing requirement. The government plans to borrow Rs 15 lakh crore in 2022-23, to finance a higher-than-anticipated fiscal deficit of 6.4 percent of GDP. This decision will complicate the policy choices for the Reserve Bank of India.

During the two years of the pandemic, when the government’s borrowing requirements increased manifold owing to high fiscal deficits, the RBI stepped in to make it cheaper for the government to borrow. It lowered the short-term policy repo rate to a mere 4 percent in March 2020. Then, through a series of unconventional actions, it bought immense quantities of government bonds and injected vast amounts of liquidity into banks, to encourage them to buy bonds as well. As a result of these actions, the rate on 10-year government securities fell to 6 percent, even as inflation kept increasing.

The increase in inflation was fairly modest, considering the extent of the RBI’s actions. In ordinary circumstances, a large increase in liquidity would encourage banks to open the credit taps, allowing firms and households to step up their spending, which would then cause inflation to soar. But during the heightened uncertainty of the pandemic, banks were reluctant to lend, households were disinclined to spend, and firms were hesitant to embark on investment projects. As a result, spending was contained. CPI inflation reached the upper limit of the RBI’s target band, but did not spin out of control.

This situation made life easy for the official sector. The government could run large deficits and the RBI a stimulative policy, without worrying about the consequences for inflation. Even better, the advanced countries were pursuing similar policies. This in turn encouraged capital to flow to emerging markets, providing India with additional liquidity and reinforcing the RBI's strategic objectives.

However, in recent months, the global macroeconomic environment has changed quite significantly. After years of price stability, developed countries are experiencing a serious bout of inflation. Inflation has jumped to 5 percent in Europe and 7 percent in the US, the highest in four decades. This change has two implications for India.

First, for the first time in decades, India is now faced with a serious case of "imported inflation". Prices are rising rapidly on all the goods India imports, from oil to investment goods to vital industrial inputs. Even food prices have increased by 20 percent year-on-year as measured by the FAO Food Price Index.

Second, as a result of this global inflation, developed country central banks are getting ready to increase interest rates and withdraw the additional liquidity they had pumped into the system during the last two years. As a result, their policy has begun to diverge from the RBI’s accommodative stance, prompting capital to flow out of India in copious amounts over the past two months. This has weakened the rupee and pushed up domestic bond rates.

With foreigners fleeing the Indian market, domestic institutions panicked when they found out about the Budget borrowing plan, because it meant that they might have to shoulder the entire burden of absorbing the Rs 15 lakh crore that the government is planning to issue. In addition, they would also need to buy whatever amount of government securities the foreign investors are planning to sell in the coming months. Unsurprisingly, the 10-year rate has shot up to 6.9 percent in a matter of days.

This brings us to the RBI. Given the changed global environment and the government’s big borrowing plan, the RBI is faced with two difficult policy options, each with associated risks.

It could resume buying government securities in order to keep interest rates in check. The problem is that buying bonds will inject even more liquidity into the system, at a time when price pressures are intensifying. This could potentially jeopardize the RBI’s objective, since CPI inflation is already running close to its legally mandated limit.

Alternatively the RBI could wind back liquidity and raise the policy repo rate. This would be consistent with its inflation targeting objective, and bring its stance in line with that of the developed countries, thereby reducing the risk of further capital outflows. But it would also push up bond rates, making it costlier for the government and the private sector to borrow.

Both options have their costs. But between the two, the RBI should worry first and foremost about the costs to society of high inflation. Inflation is a tax that falls heaviest on the poorest, the most vulnerable segment of the society. And once inflation starts rising, it becomes very difficult and costly to bring it down, as we learned from our painful experience during 2013-14, when short-term interest rates reached 12 percent. As for bond rates, ultimately they need to be determined by demand and supply, without interference from the central bank, as this is the only way to ensure that they reflect the real cost of capital.

It will be interesting to see which way the RBI goes.

Why it’s not time to cut taxes

Indian Express, January 31, 2022

With the Union Budget round the corner, many people hope that taxes will be cut to boost private spending and growth. While ordinarily this might be a good idea, there are four main reasons why tax cuts are not prudent now.

First, the strong revenue performance during 2021-22 gives a misleading impression of the government’s fiscal position. Revenues this year have benefitted from some exceptional factors: (i) strong profit growth in the private corporate sector, led mostly by the large firms; (ii) robust collections from the Goods and Services Tax (GST); and (iii) rapid GDP growth. The crucial question to ask is what might happen to these factors in 2022-23. And here we run into some difficulties.

It is risky to assume that corporate profit will continue to grow rapidly going forward. This is because we do not yet fully understand what led to the growth in 2021-22. If we look at the data of listed non-financial, non-oil firms in the private sector, we find that by June 2021, their profit margins were higher than the pre-pandemic period. This could have been the result of an increase in their market share, given that the smaller firms bore the brunt of the pandemic. The larger firms also took emergency measures to cut costs. It is not obvious that as the pandemic recedes, the same trend will continue in 2022-23. If it does not, then corporate tax growth would not be as high as in 2021-22.

In addition, GST growth is likely to slow down. In 2021-22, average monthly collections increased to Rs 1.2 trillion from Rs 0.94 trillion in 2020-21. This increase was mostly on account of resumption of economic activity. GST on imports also played a big role, fuelled by an import boom and higher tariffs. It is unlikely that we will witness a similar import boom next year.

As the recovery period ends and the economy normalizes, GDP growth will slow down too. The main engine of growth for an emerging economy like India is private sector investment, which still shows no signs of acceleration, even as the broader economy recovers. Another engine of growth is exports. While India experienced an export boom in 2021-22, as the developed countries normalise their macro-policies, the global exports boom will diminish, and this will impact India as well. Hence it is not certain where a high GDP growth will come from in the next fiscal year.

All these factors lead to uncertainty about tax revenues.

Second, the fiscal deficit, targeted at 6.8 percent of GDP for 2021-22, continues to be very high. There is little room to cut spending, since demands for social spending such as on NREGA remain high, interest payments continue to be a big component of expenditure, and there is mounting pressure on the government to increase capital expenditure. There is consequently no room to provide tax relief without imposing further pressure on the deficit. Nor is it a good idea to allow the deficit to increase. Government’s total debt has already reached 90 percent of GDP, the highest ever, and there is significant pressure on the bond yields to go up, which would make it costlier for everyone to borrow.

Third, the pandemic has caused supply shortages the world over. In India too we have been experiencing supply chain bottlenecks. In a supply-constrained environment, any attempt to boost demand by increasing households’ after-tax income would lead to inflation. This is exactly what has been happening in the US and other developed economies. In India, CPI inflation has been running at 5-6 percent, close to the upper limit of the RBI’s target band. And already there are pressures for inflation to go up, coming from rising oil and commodity prices. Tax cuts and the resultant increase in spending might push inflation beyond the limit, forcing the RBI into an uncomfortable choice: raise interest rates sharply at a time when the recovery is beginning or allow inflation to tax the country’s poor.

Finally, globally we are entering into a period of macroeconomic uncertainty. The US economy is experiencing its highest inflation in 40 years. The US Fed will consequently raise interest rates this year. When the developed world pulls back their expansionary policies, it is important for emerging economies like India to display strong macroeconomic fundamentals, and for the government to come across as credible.

One of the key reasons India was badly affected by the Taper Tantrum episode of 2013 was because it was doing poorly on macro fundamentals. In a way, the situation now is not very different. Once again, we are running a high fiscal deficit and the real interest rate is negative because inflation is higher than the policy rate. True, inflation is lower than it was in 2013, but the government debt ratio is substantially higher. Hence, the government needs to be somewhat careful about its fiscal math.

With state elections coming up, it might be tempting for the government to slash taxes and win votes. But given its own fiscal limitations and the uncertainty surrounding India’s growth and inflation trajectories in the next fiscal year, this would not be a prudent call.

Is GDP data a reliable way to measure the health of the economy?

Indian Express, January 4, 2022

The primary yardstick that analysts use to measure the economy’s health is GDP. Economists, technocrats and journalists cite GDP numbers when crafting their narrative about how well the economy is recovering from the pandemic. The Reserve Bank of India and multilateral agencies use GDP statistics to make claims about the future growth path. Yet no one seems to be asking the most important question: How reliable are the Indian GDP data?

The CSO released the current GDP series in 2015, using 2011-12 as its base year. Since then, the new series has been embroiled in controversy. Scholars have pointed to measurement problems, both in the nominal GDP numbers and the real GDP growth rates. Yet none of those problems has been addressed by the CSO, to the best of our knowledge. As a result, the measurement errors still persist.

There are three major reasons why the GDP data, and hence any narrative of economic recovery based on it, are questionable.

First, the growth rate of real GDP is contaminated by the "double deflation problem". Simply put, the CSO calculates real GDP by gathering nominal GDP data in rupees and then deflating this data using various price indices. The nominal data needs to be deflated twice: once for outputs and once for inputs. But the CSO – almost uniquely amongst G20 countries – deflates the nominal data only once. It does not deflate the value of inputs.

To see why this is a problem, consider what happens when the price of imported oil goes down. In that case, input costs will fall and the profits recorded by Indian firms will rise. This increase in profits is merely the result of a fall in input prices, so it needs to be deflated away. After all, GDP is meant to measure the amount of production in the country, which hasn’t changed, at least in the first instance.

But the CSO doesn’t deflate away the increase in profits. Instead, it records a purely nominal increase as a real increase in GDP, thereby overstating growth. Simulations have shown that this effect can be substantial. For further information, see my article here.

Since the cost of inputs is measured by the WPI, a crude measure of the overestimation caused by the absence of "double deflation" is given by the gap between the WPI and the CPI. In the 2014-2017 period, oil prices plunged, causing the WPI to fall sharply relative to the CPI. This meant that real growth was probably overstated.

In the last few months, the exact opposite has been happening. WPI inflation is soaring, reaching 14 percent in November, while CPI inflation has "only" been 5 percent. The rapid increase in the WPI relative to the CPI is imparting an upward bias to the deflator, which increased at the remarkable rate of 8 percent in the second quarter of 2021-22. If this deflator is being overestimated, then real GDP growth rate could be underestimated right now.

A second reason why growth might be underestimated is that the CSO has not updated the sectoral weights. When the CSO calculates GDP, it takes a sample of activity in each sector, then aggregates the figures by using sectoral weights. To make sure that the weights are reasonably accurate, the CSO normally updates them once a decade. It has now been more than 10 years since the weights were changed, and there are no signs of a base year revision. As a result, the sectoral weights are still based on the structure of the economy in 2010-11, when in particular the information technology sector was much smaller. In other words, the fast-growing IT sector is being underweighted, which implies that GDP growth is being underestimated.

But before we jump to conclusions, we need to take into account the third measurement problem – which works in the opposite direction. Measurement of the unorganised sector has always been difficult in India. Once in a while, the CSO undertakes a survey to measure the size of the sector. In the meantime, it simply assumes that the sector has been growing at the same rate as the organised sector. This practice was working well when the two sectors were moving in tandem.

However, starting in 2016 the large unorganised sector has been disproportionately impacted by a series of shocks. First came the demonetisation shock of 2016, which was a severe blow to cash-dependent firms in this sector. Next came the implementation of the Goods and Services Tax (GST) from 2017 onwards, which necessitated a particularly difficult and costly adjustment for unorganised sector enterprises. Then in 2018 came serious problems in the NBFC sector, in turn creating problems for unorganised sector firms, since they were heavily dependent on NBFCs for funding. Finally, the Covid pandemic from 2020 onwards was undoubtedly a much bigger shock for the unorganised sector, compared to the organised sector enterprises.

Despite these severe shocks, the CSO does not seem to have made any adjustments to their methodology for estimating unorganised sector growth. They apparently continue to assume that unorganised sector enterprises have been growing as fast as those in the organised sector. In that case, there would be an upward bias to reported GDP growth.

So, what is the bottom line? Can we say whether the latest GDP numbers overstate or understate growth? The answer is no, because the measurement problems go in different directions. Without more information from the CSO on their methodology we cannot say whether the positive factors outweigh the negative one, or vice versa. But what we can be clear about is that there are serious problems with India’s GDP data. Hence any analysis of recovery or any forecast of future growth of the Indian economy based on this data must be taken with a handful of salt!

Thinking about financial sector reforms in India

Thinking about financial sector reforms in India, Ideas for India, November 15, 2021.