Inflation, deflation and Raghuram Rajan

Chief Economic Advisor Arvind Subramaniam thinks the Indian economy may now be in deflation territory. Deflation is a fall in prices. The WPI has been in decline. Subramaniam's remarks are seen as a broad hint to the RBI to cut interest rates.

But trends in WPI have little bearing on the RBI's policies given the monetary policy framework within which the RBI is now operating. In this framework, the focus is resolutely on CPI and the objective is to bring the CPI down to 6% by January 2016.

Those want a rate cut make two arguments. CPI is below 4%, which is below the 6% target, hence there is a compelling case.Two, a cut in the rate will stimulate growth. In a recent speech, Rajan addresses both arguments:

 To take the first argument first:

The statement “Inflation is low, you can now turn to stimulating growth” also perhaps reflects a misunderstanding of how central banking works. Monetary policy works with a lag of 3 to 4 quarters. So in deciding policy today, we need to predict how inflation will look approximately a year ahead. Today’s inflation therefore matters only in informing us about future inflation. However, today’s inflation measured on a year on year basis may be low because there was an unexpected price spurt last year – the so-called base effect.

So we need to take out base effects before we even assess the information from current inflation, something many observers fail to do. Also, there may be many sources of uncertainty that cloud the future inflationary picture and disconnect it from current inflation – the strength and distribution of the monsoon, the extent and persistence of low commodity prices, the effect of external disturbances on the exchange rate, etc. In practice, we use models to project how all this might play out on inflation, and we overlay the models with the subjective assessments that our internal committee and its advisors offer, to ultimately arrive at a policy decision.

Our model based assessments of the inflation path are almost surely going to differ a little from the realization, given that the world is uncertain, but they are our best professional assessments, and we set policy based on those assessments. As information comes in, monetary policy is adjusted – for instance, the substantial disinflation from November 2013 gave us confidence about the persistence of low inflation into the future, allowing us to cut the policy rate three times.

What such an approach rules out is what might best be described as “inflation following policy” that some populist commentators on monetary policy advocate.

In other words, the policy rate is set based, not on past inflation, but on expected inflation. Given that the RBI is committed to an inflation target of 6 per cent and has to explain any failure to meet the target, the tendency will naturally be to err on the side of caution- and any number of indicators can be found in the future to support such caution. The inflation targeting framework thus creates a bias against rate reduction.

As for the second argument, Rajan has this to say:

Modern economic theory suggests there is indeed a short run trade-off between inflation and growth. In layman’s terms, if the central bank cuts the interest rate by 100 basis points today, and banks pass it on, then demand will pick up and we could get stronger growth for a while, especially if economic players are surprised. The stock market may shoot up for a few days. But if the economy is supply constrained, we could quickly see shortages and a sharp rise in inflation. The central bank may then be forced to raise interest rates substantially to offset that temporary growth. The boom and bust will not be good for the economy, and average growth may be lower than if the cut had not taken place. This is why modern economics also says there is no long run trade-off between growth and inflation – the best way for a central bank to ensure sustainable growth is to keep demand close to supply so that inflation is moderate.

This is true when the economy is operating at its full output potential. Today, the Indian economy is not because projects are stalled on the ground, partly for want of funds. Cutting the interest rate impacts the supply side as well, not just the demand side. How? By increasing retained earnings, it improves the debt to equity ratio of companies. Some companies can access debt, some can access more equity. Projects can be completed and supply can increase. Further, the rate cut increases the value of securities held by banks and is a clever way of recapitalising them. With more capital at their disposal, banks are more ready to make loans and take risks. A rate cut thus can have important supply-side effects in the situation we are in.

A cut in the interest, of course, provides a stimulus to demand. it lowers the cost of capital and makes some fresh investment feasible. It stimulates demand for housing from consumers and allows housing stock to sold, making cash flows available to builders.