By Jatin Bavishi
Inflation is a frequent buzzword in the academic and policy cliques. In common parlance, inflation implies a rise in the general price level of an economy from a given point of reference but the process behind it is complex. It is at this juncture that a rift arises between the popular and professional notions of inflation with little guarantee of recourse. Inflation is a marquee notion and there exists a family of such measures (Consumer Price Index, Wholesale Price Index, etc.) that try to contextualise the actual process.
It will be folly to equate all price rise as necessarily inflationary. Prices may scurry up or down depending on structural features of the economy, but inflation is specifically a position of disequilibrium. The harmful consequences of inflation follow from this unanticipated and staggering feature, leading to instability and uncertainty. Present decisions of agents (be it firms or households) rely on their future expectations (which might now always be same), but uncertainty introduces a nuance of volatility.
Where does inflation stem from?
Inflation emanates from a multitude of sources- it can either be the result of aggregate supply falling short of the aggregate demand as a result of an increase in costs of production or an outcome of overheating whereby an increased demand outstrips the supply of the economy. It is important to distinguish between these two.
The RBI currently has the sole mandate to target inflation in India. In fact, it is answerable to the Central Government in case there is a failure to keep inflation within the bound of 2% to 6% for three consecutive quarters. To recapitulate some basics, a fall (rise) in interest rates reduces (increases) cost of borrowing, which in turn encourages (discourages) inflationary tendencies. To be sure, interventions are done both by Government and Central Banks, which are respectively classified as Fiscal and Monetary policies. The former does it by tweaking tax rates or increasing investments, but the latter controls the circulation of money supply (amount of money held by the public) in the economy.
Analysing the Indian economy
A substantial bulk of Indias money supply falls outside formal institutional systems (such as in real estate or gold or other forms of black money) which erodes the efficacy of monetary policy. The RBI recently changed the method used by banks to lend from Base Rates to Marginal Cost of Funds based Lending Rates (MCLR) to smoothen the pass through. Yet, it is far from perfect. Given its mandate to control inflation, the RBI anchors its policy on Consumer Price Index (CPI). However, unlike the US or other consumption-driven economies, most of the credit in India is for production purpose, which again reduces the volition of RBI over consumer spending. In the extreme case, it may so happen that even if banks pass over the entire change in policy rates, its impact on CPI numbers might be zero. It must be added that the present anchor CPI is much better than the earlier used Wholesale Price Index (WPI) which does not even feature Services.
The recurring inflation in India is mostly on the sectoral supply side factors. Oil and essential food grain prices are the regular culprits. As already mentioned, these changes may not always possess long term ramifications (crop loss due to failed monsoons may yield fortunes next season and oil prices may shoot up owing to the political crisis in the Gulf, which might subside early). This does not auger well for RBIs monetary policy which has no control over these supply side factors. Moreover, their actions have an impact on all sectors of the economy and not necessarily on the two mentioned above. All of these show the difficulties RBI faces in its policy stance.
Utility of the monetary policy
Since RBI has limited control over inflation in India, their policy is, in reality, a signalling mechanism to the agents as regarding their intentions. This is also an exercise to establish its credibility as an autonomous institution- devoid of being affected by political pressures. Hence, for example a contraction in monetary stimulus on the face of crop failures is a signal to show their commitment in terms of its priority to control inflation, despite knowing their inability to control agricultural output directly in the short run.
All this is not to suggest that if all the bottlenecks mentioned above are removed at one stroke, inflation targeting would be easier. Targeting assumes fully rational agents possessing an unbounded ability to process infinite information. Various studies in behavioural sciences have shown rationality to be bounded.
These are quite contrary to the objectives of the fiscal authorities, whose intentions on inflation is mainly to ameliorate short run and sectoral distress. The antagonism between the two authorities is but inexorable, but it is healthy for an economy.
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