Rajans Target Inflation or the Poor
1
COMMENT Economic & Political Weekly EPW march 29, 2014 vol xlix no 13 9 Rajan’s Target: Inflation or the Poor? Inflation targeting is intended to protect the poor, but it does not work that way. Rohit writes: R eserve Bank of India (RBI) Governor Raghuram Rajan said that Parliament should set inflation targets for the central bank to follow. On the face of it, this looks like the RBI is trying to hold itself accountable to the elected repre- sentatives of the people, especially where the interests of the poor are concerned. But is that really so? Targets have become the rule of the day with the Fiscal Respon- sibility Budgetary Management ( FRBM) Act taking the lead on the fiscal front and now inflation targeting ( IT ) on the monetary front. A lot has been written about the FRBM from opposite per- spectives but the policy of IT in India is a more recent pheno- menon. India has been witnessing significantly high rates for in- flation since mid-2009 and, except for some blips here and there, inflation has continued to remain quite high. This obviously hurts those whose income is not indexed to inflation. There are broadly two categories of people who are hurt most by inflation. One obvious group is the poor; the not-so-obvious group con- sists of those who have invested in financial assets, the real val- ue of which depreciates with inflation. The way IT works is that it is assumed that there is a trade-off between inflation and output; so to bring inflation down one needs to reduce the level of output (thereby the level of employment too gets affected). Output can be brought down with a higher rate of interest, which would adversely affect two of the most important components of total output, private investment and credit-financed consumption. On the face of it, this policy stance looks just fine. But there is many a slip between the cup and the lip, in particular if the underlying assumption of a trade-off between output and inflation turns out to be incorrect. Output is normally assumed to be posi- tively related to inflation because the per unit cost of production is assumed to increase with output. This can happen for a variety of reasons: the strength of labour unions can grow with an increase in employment which leads to stronger wage demands; the produc- tivity of inputs like labour can decrease with increased usage (in the jargon of economics, there is diminishing marginal productivity of labour); supply constraints on other inputs can push up their prices. So, any reduction of production is supposed to bring down the costs of these factors and, thereby, inflation. But what if these reasons do not hold in a developing country like ours? For a developing economy like India with a vast reserve army of labour (reflected in a large unorganised sector), assuming a rise in the bargaining strength of the working class alongside a growth in employment seems very distant from reality. Moreover, if the usage of all inputs is rising in tandem there is no reason why an additional unit of output will cost more than the previous unit. In other words, there hardly seems to be a direct relation- ship between output and inflation. Therefore, any policy to control inflation by targeting a lower level of output will be counter- productive. It will not only not control inflation it will also increase unemployment and create fears of a recession which could further fuel such pessimistic expectations. That this has been witnessed by India in the last two-three years should not come as a surprise. While the index of industrial production ( IIP ) has seen a declin- ing trend in growth over the period of a continual hike in interest rates, inflation has hardly abated except in the rise in prices of commodities where the monsoon has played a supportive role. This brings us to the question of why inflation has been so stub- born over the past few years. The answer to this question lies in looking at the cost rather than the demand side. Kalecki, a Marxist economist, had proposed that while prices of industrial commodities are cost-determined, those of primary commodities are demand- determined. Indeed, can one say that the prices of automobile rise just because there has been a surge in its demand? On the other hand, this can be true for agricultural commodities. So it is obvious that inflation which has entered the system with the rise in prices of the latter, cannot be controlled by bringing down the production of the former. Moreover, inflation because of a rise in prices of critical imported inputs like oil (because of an increase in dollar prices and/or depreciation of the rupee) also cannot be controlled by bringing down production and employment. For primary commo- dities, inflation essentially follows from inadequate and volatile production, speculative hoarding and commodities futures. What the government needs to do then is not follow a conventional IT ap- proach but attack the real sources of inflation by (a) countercyclical taxation of oil and related items (increase tax rates when their prices in rupee terms are low and vice versa); (b) improvement and investment in storage capacities across the country; (c) controlling the futures market; and (d) cracking down on commodity hoarders.
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Transcript of Rajans Target Inflation or the Poor
COMMENT
Economic & Political Weekly EPW march 29, 2014 vol xlix no 13 9
Rajan’s Target: Infl ation or the Poor?
Infl ation targeting is intended to protect the poor, but it does not work that way.
Rohit writes:
R eserve Bank of India (RBI) Governor Raghuram Rajan said that Parliament should set infl ation targets for the central bank to follow. On the face of it, this looks like
the RBI is trying to hold itself accountable to the elected repre-sentatives of the people, especially where the interests of the poor are concerned. But is that really so?
Targets have become the rule of the day with the Fiscal Respon-sibility Budgetary Management (FRBM) Act taking the lead on the fi scal front and now infl ation targeting (IT) on the monetary front. A lot has been written about the FRBM from opposite per-spectives but the policy of IT in India is a more recent pheno-menon. India has been witnessing signifi cantly high rates for in-fl ation since mid-2009 and, except for some blips here and there, infl ation has continued to remain quite high. This obviously hurts those whose income is not indexed to infl ation. There are broadly two categories of people who are hurt most by infl ation. One obvious group is the poor; the not-so-obvious group con-sists of those who have invested in fi nancial assets, the real val-ue of which depreciates with infl ation.
The way IT works is that it is assumed that there is a trade-off between infl ation and output; so to bring infl ation down one needs to reduce the level of output (thereby the level of employment too gets affected). Output can be brought down with a higher rate of interest, which would adversely affect two of the most important components of total output, private investment and credit-fi nanced consumption. On the face of it, this policy stance looks just fi ne. But there is many a slip between the cup and the lip, in particular if the underlying assumption of a trade-off between output and infl ation turns out to be incorrect. Output is normally assumed to be posi-tively related to infl ation because the per unit cost of production is assumed to increase with output. This can happen for a variety of reasons: the strength of labour unions can grow with an increase in employment which leads to stronger wage demands; the produc-tivity of inputs like labour can decrease with increased usage (in the jargon of economics, there is diminishing marginal productivity of labour); supply constraints on other inputs can push up their prices. So, any reduction of production is supposed to bring down the costs of these factors and, thereby, infl ation. But what if these reasons do not hold in a developing country like ours?
For a developing economy like India with a vast reserve army of labour (refl ected in a large unorganised sector), assuming a rise in the bargaining strength of the working class alongside a growth in employment seems very distant from reality. Moreover, if the usage of all inputs is rising in tandem there is no reason why an additional unit of output will cost more than the previous unit. In other words, there hardly seems to be a direct relation-ship between output and infl ation. Therefore, any policy to control infl ation by targeting a lower level of output will be counter-productive. It will not only not control infl ation it will also increase unemployment and create fears of a recession which could further fuel such pessimistic expectations. That this has been witnessed by India in the last two-three years should not come as a surprise. While the index of industrial production (IIP) has seen a declin-ing trend in growth over the period of a continual hike in interest rates, infl ation has hardly abated except in the rise in prices of commodities where the monsoon has played a supportive role.
This brings us to the question of why infl ation has been so stub-born over the past few years. The answer to this question lies in looking at the cost rather than the demand side. Kalecki, a Marxist economist, had proposed that while prices of industrial commodities are cost-determined, those of primary commodities are demand- determined. Indeed, can one say that the prices of automobile rise just because there has been a surge in its demand? On the other hand, this can be true for agricultural commodities. So it is obvious that infl ation which has entered the system with the rise in prices of the latter, cannot be controlled by bringing down the production of the former. Moreover, infl ation because of a rise in prices of critical imported inputs like oil (because of an increase in dollar prices and/or depreciation of the rupee) also cannot be controlled by bringing down production and employment. For primary commo-dities, infl ation essentially follows from inadequate and volatile production, speculative hoarding and commodities futures. What the government needs to do then is not follow a conventional IT ap-proach but attack the real sources of infl ation by (a) countercyclical taxation of oil and related items (increase tax rates when their p rices in rupee terms are low and vice versa); (b) improvement and investment in storage capacities across the country; (c) controlling the futures market; and (d) cracking down on commodity hoarders.
