The Hindu Business Line : Central banks are inflation anchors

Inflation pushed above 8 per cent in the data released last Friday, leading to an immediate flurry of speculation on its impact on interest rates. Will the RBI increase the repo rate yet again?

It has every reason to. But these are difficult times. Growth is ebbing (although that is still not showing up in headline data). Stocks and property - the main asset markets – are cooling. To the extent that the asset price boom added to growth, this must be reckoned a dampening factor.

So what is the RBI to do? It is not short of advice. Authority is present as the Prime Minister’s Economic Advisory Council, headed by the respected Dr C. Rangarajan. Then you have the RBI’s Technical Advisory Committee on monetary policy.

The Planning Commission does its bit through its Deputy Chairman and distinguished economist, Mr Montek Singh Ahluwalia. On top of these are the numerous, well-meaning commentators, comprising academics, ex-Governors, Deputy Governors, Advisers and civil servants.

And we do not lack homilies in plenty from foreign economists and bankers either. It must be quite a task for Dr Y.V. Reddy and his colleagues just to sift the wheat from the chaff.

There is a sure formula to bring down inflation, even to zero — just increase interest rates and contract money supply sufficiently, which the former US Fed chairman, Mr Paul Volcker, did with telling effect in the early eighties.

growth & inflation

The problem and debate has always been about the trade-off between growth and inflation. (Of course, the diehards maintain this is an illusion — only a single-minded focus on inflation ensures long-term growth.

In rational expectations, this is carried further — you cannot win even short-term growth with monetary stimulus). The inflation target adopted by several central banks must not be confused with monetarist beliefs, but seen as a division of responsibility between governments and central banks.

Some armchair ideas to arrest inflation are a bundle of contradictions.

One cannot argue that the rupee should be allowed to appreciate, but interest rates must be left alone! Exchange rate appreciation is equivalent to monetary tightening and a quasi-substitute for higher interest rates.

The RBI surely knows this and has struck a fine balance between the two in its policy and market actions.

The current global inflation problem is clearly because of demand growth in the newly-industrialising countries of the world. Mass affluence is no longer the monopoly of the West nor is extraordinary wealth confined to just a small part of the world. Unsurprisingly, commodities, which are at the beginning of the supply chain, exhibit the strongest upward price moves. In the short run, their supply elasticity is near zero, but that could change dynamically and dramatically in response to price signals as has happened in several similar situations in the past.

Monetary policy, in these circumstances (and always), has a key role in anchoring inflation ‘expectations’. It is the most important mandate of the modern central bank.

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