Does high Indian inflation need 'monetary' cure?

It would appear so if the objective is to bring inflation down on an enduring basis to below the double digit level on a sustained basis. Indeed, short of the monetary aggregates’ target policy of the legendary US Fed Reserve chairman Paul Volcker, adopted in October 1979 and which enduringly killed US inflation in the decade of the 1980s and 1990s, India could be vulnerable to high and variable inflation, of the type which dogged much of the Western world (barring the erstwhile West Germany) through the 1960s and the 1970s. A monetary aggregates’ target policy would be quite painful in the short-term but it could well be the bitter medicine India has to gulp down to ensure more stable and, therefore, more sustainable economic growth over the medium term.

As this piece is being written (12 September), there has, of course, been a slight dip in the Y-o-Y inflation figures being reported in the last three weeks – from 12.40 per cent to 12.34 per cent to 12.10 per cent respectively. There could be further small downward moves in the officially reported Y-o-Y inflation data by the time this piece is published. (The low base of the earlier year may preclude large moves down in the Y-o-Y number). But, not only could the downward adjustments be small, they could well be ephemeral also if the underlying forces driving inflation in India are not rolled back. Without attacking the underlying causes of the disease, the Indian economy may be exposed to higher and more variable inflation with damaging side effects on output and employment.

Excess demand; but how?
Policy makers routinely say that the present high inflation has been caused by a combination of supply-side pressures and demand-side factors and that demand management is also essential in this environment. But official statements do not go further to identify the factors (or the underlying causes) which play an important role in the formation of excess demand pressures.

For, those factors are, to quite some extent, the end result of the policy stances adopted by the policy makers themselves. The reference here is to the exchange rate policy adopted by India, which results in massive expansion of the central bank’s balance sheet and broad money supply which in the absence of a commensurate increase in money demand then spills over into excess demand for goods and services and overall price level pressures.  Demand management takes the form of monetary tightening and attempting to push market interest rates up. But given the continuing boost to money supply growth (and excess demand pressures) which the overall FX policy results in, it is more like running with the hare and hunting with the hound for the policy maker. It then becomes quite difficult to get and be ahead of the curve.

The latest blip on the FX reserves front (reserves having declined by around $ 20 billion in the two month period up to 5 September 2008) does not materially alter the overall picture depicted above. A drain on the FX reserves technically does represent a concomitant reduction in reserve money supply in the financial system and, therefore, a reduction in overall money supply. But one has to qualify the reserves dip in India with the fact that a (good) part of the reserves drop is on account of FX sales to the Indian oil companies which has been (rupee) financed by the Reserve Bank of India itself. (On any given day, the RBI has undertaken to buy up to Rs.1500 crore of oil bonds from the oil companies which the companies can use to buy FX from the RBI). Further, hard currencies such as the euro and the British pound have fallen by around 10/12 per cent against the dollar in the past couple of months and these value losses are getting reflected in (dollar terms) in the overall reserves. Therefore, at the aggregate level, there is no material impact on the money supply but only book entry adjustments in the RBI. More importantly, it has been recently reiterated that the exchange rate policy followed so far has served the country well and will be persisted with.
 
Seeds of the inflation crisis  
In the economics profession, it is said that the seeds of an inflation crisis are sown several years in advance and it is not always easy to see the seeds as they sprout. This could well characterize the situation obtaining in India today.
In our view, the seeds of the present inflation crisis have been sown by the high level of money supply growth in the past 10 years – averaging 17 per cent p a. This has far exceeded the ‘real’ output growth in the economy, on average, of around 7 per cent. Combined with a non-commensurate increase in overall money demand, the excess money supply is now manifesting itself as high inflation. Unfortunately, the period of high money supply growth in India well coincided with a global commodities price boom phase also accentuating the demand pressures.

Unless money supply growth is brought down to a more manageable level (that level being a function of the long-term real output potential of the economy as well as the size of overall money demand which in turn depends significantly on the level of transaction money demand), we foresee continued pressures on prices. Bringing down growth in money supply depends on two crucial factors –

1.  Slowing down the pace of accretion in the country’s foreign exchange reserves
2.  Moderating the creation of credit / loans in the financial system 

How and why excess money supply impacts prices
Though the quantity theory of money (QTM) (and its emphasis on the monetary aggregates) has not been a major input in global monetary policy formulation in recent years (barring the ECB), it does not mean that the QTM concepts can be totally discarded, at least in the case of EMEs such as India. Also interestingly, a careful perusal of economic history would reveal that Indian monetary policy formulation, its approaches, its compulsions and its ‘co-ordination’ with overall government policy of the past 20 years is quite similar to how the US Fed conducted policy in the 1960s and 1970s in ‘sync’ with the US Federal government. Indian macro economic policy making now is where the US was three decades ago. The bottomline in both the approaches is massive monetary expansion, accommodation of fiscal policy and consequently a diluted price stability objective. Therefore, emphasis on the monetary aggregates may be as relevant for india now as it was for the US in 1979 /1980.

Quite simply, given a certain level of growth in money supply and a certain long-term real output growth potential of the economy (real GDP), money demand in the economy also has to rise at such a level as to absorb the (excess) money supply, so that there is no spill over into the price level. Where money demand growth stagnates or does not keep pace, the impact is bound to be felt on inflation.

The key to increasing money demand
Given certain policy predilections – such as the preference for massive intervention in the FX markets and the build up of FX reserves and the fact that credit growth in the financial system cannot be stymied too much because of the growth objectives, it is clear that not much leeway is available to the policymaker to ensure that the available money supply is absorbed in a non-inflationary manner. The structural or long term solution, therefore, to avoid a spill over of excess money supply into the overall price level is increasing moneydemand (particularly transaction money demand) in the economy. For that to happen, we need a massive qualitative expansion of banking and financial services facilities to actually achieve ‘financial inclusion.