Indian monetary policy borders on schizophrenia

There are no prizes for stating that India has an inflation problem. Double-digit inflation in food, fuel and commodities are writ large. Wednesday, the Opposition party brought the Parliament to a standstill. The ostensible reason was price hikes and inflation. While the political elite's concern for the common man's woes is almost touching in its self-serving hypocrisy, the fact of the matter is there are no easy answers. Neither do the technocrats who man the ships of Indian finance really comprehend how to tame the dragons of inflation in any immediate fashion. And they aren't too blame, at least entirely, either. The nature, reason and resolution of the inflation problems are deep and structural.

Ever since the days of Walter Bagehot's Lombard Papers in the 19th century, bank collapses, financial panic, monetary expansion and real economy have consistently formed a remarkably pedagogical quartet. Nevertheless, modern central banking has largely been a byproduct of institutional responses to structural issues that emerged during the interregnum between the two world wars and thereafter in the industrialised world. This world was, and now is, marked by monetary transmission mechanisms that propagate extensively throughout the economy. Modern monetary policy is hand-in-glove with a macroeconomic industrial policy that is embedded in an environment marked by standardised terms of financing, legal frameworks, risk management, credit policies, financing strategies etc. Other than the idiosyncratic details that respective industries (say, chemicals vs semi-conductors) have, their underpinnings and incentives are similar. In contrast, the developing world, for example India, has self-evident structural cleavages that impair conventional monetary policy and reduce their efficacy.

As is becoming increasingly clear, India's inflation is generated from a supply side. Weak monsoons, food hoarding, governmental subterfuge, who connive with rich farming lobbies et al, have contributed to it. It's clear that with this cost-push inflation, the Reserve Bank of India (RBI) fights a battle with one hand tied behind its back. To make matters worse, it's obvious that with the scale of uneven economic growth, the RBI has no real tools to affect the cost of capital in far flung areas of India, say Aizwal or Tuticorin, except in some sledgehammer manner of response by raising the benchmark rates, which eventually trickles down to the cooperatives and small regional banks. Yet, the politics of raising benchmark lending/borrowing rates is overwhelmingly dominated by banking-industrial complexes in Chennai, Delhi and Mumbai. And if the inflation story is anything to go by, inflationary pressures across India have different sources, different feedback loops than any that the RBI can control or affect.

Interventionist policy

To make this hypothesis clearer, it is instructive that the RBI has yet again intervened to affect the cost of borrowing and lending as of yesterday. The RBI has yet again raised the repo (lending) and reverse-repo (purchase) rates up to 5.75 per cent and 4.5 per cent respectively. And this time the rate hikes are asymmetric; in that lending rates went up by only 0.25 per cent, while the borrowing rate went up by 0.5 per cent. This is the fourth policy-induced rate hike this year. Wow. The RBI is quite explicitly and openly confessing to being asleep at the wheels, as one might uncharitably put it, and of playing catch up to the macroeconomic events. Furthermore, all of this comes as the credit reserve ratio (the proportion of deposits that banks must hold as cash) is held constant at 6 per cent. The argument here is that with the spectrum sales in recent months, a large amount of liquidity in the system has been siphoned away and keeping the CRR constant will enable the monetary authorities to keep liquidity in the banking system. The banks themselves have borrowed Rs200 billion to Rs300 billion over the past two months in an environment where deposits aren't rising. In contrast, changing the rates of borrowing and lending affects marginal behaviour, by affecting the cost of capital investment. The explicit effect of such rate hikes, as per theory, and some heuristics, is that going forward, new projects may not take off and the current projects, tottering on edges of financial feasibility, might slowly peter off etc. None of this however gives one confidence that inflation is any time likely to be tapered off. Many are touting victory that "inflation has cooled off" if the food prices drop month-over-month from 17 per cent to 12 per cent. This is an absurd consolation.

Even within the RBI there's increased number of voices that articulate a view that inflationary pressures are largely structural. To use the word "structural" is often a euphemism to say political actors have played the system of food-hoarding, credit-lending in smaller cooperatives etc., As Subir Gokarn, the Deputy Governor of the RBI has acknowledged, "the significant part of the rise in food prices was structural in nature".

In essence, the RBI can only do so much and not more. The travesty is that there's a consensual hallucination in much of the press and elsewhere that, somehow, as far as inflation goes, the buck stops with the RBI Governor. Nothing could be further than the truth however. The politics of India has to step up. Systemic improvement in food storage and irrigation, improved agricultural yield, reduced monopolistic pricing companies, greater levels of investment in agricultural, risk-management etc., are prerequisites for a well-functioning monetary system in an agricultural economy. Failing which monetary policy shall be a hand maiden of the industrial India with little meaningful policy impact on nearly 70 per cent of Indians. A silver lining, if there is any, that from these rounds of inflationary spirals in food and commodities, we'll find that the political clamor to improve the productivity and efficiency of the India agricultural system will increase further.

For the foreseeable future, however, the RBI will play more of a firefighting role in the economy which is racked by inflationary pressures.

The columnist works for a major European investment bank in New York City. You can follow his tweets at http://twitter.com/ks1729.