I thank the Tata Institute of Fundamental Research for inviting
me to give this Foundation Day lecture. I have always seen TIFR with awe
from afar. Some explanation is in order. My roommate in my first year
at MIT was Dr. Renganathan Iyer, who is one of the smartest
mathematicians I know – he used to help me understand my tutorials in
real analysis. And he never missed an occasion to tell me how much
smarter everyone else at TIFR was. Perhaps Renga was being modest, but I
half expected on coming here today to see everyone with gigantic heads
housing enormous brains. It is a relief to find that, outwardly, you all
look normal. Seriously, however, I think the continuing success of TIFR
suggests to us that when India wants to set up world class
institutions, it can. While the Institute was fortunate to have a
visionary like Dr. Homi Bhabha as its founding director, the institution
has been built by the collective efforts of dedicated researchers like
you all. Congratulations on a job well done!
In my speech today, I thought I would describe our efforts to build a
different kind of institution, not one that delves into the deepest
realms of outer space or into the tiniest constituents of an atom, but
one that attempts to control something that affects your daily life;
inflation. There are parallels between the institution building you have
done, and what we are setting up to control inflation, though clearly
our efforts are much less tied to investigating the very fabric of the
universe and more towards influencing human behavior. Ultimately, both
require a fundamental change in mindset.
The Costs of Inflation
High inflation has
been with us in India for the last four decades. Most recently, we have
experienced an average of more than 9 percent inflation between 2006 and
2013.
What are the costs of having high inflation? Clearly, everyone
understands the costs of hyper-inflation, when prices are rising every
minute. Money is then a hot potato that no one wants to hold, with
people rushing straight from the bank to the shops to buy goods in case
their money loses value along the way. As people lose faith in money,
barter of goods for goods or services becomes the norm, making
transacting significantly more difficult; How much of a physics lecture
would you have to pay a taxi driver to drive you to Bandra; moreover
would the taxi driver accept a physics lecture in payment; perhaps you
would have to lecture a student, and get the student to sing to the taxi
driver…you get the point, transacting becomes difficult as
hyperinflation renders money worthless.
Hyperinflation also has redistributive effects, destroying the middle
class’ savings held in bonds and deposits. The horrors of
hyperinflation in Austria and Germany in the 1920s still make scary
reading.
So clearly, no one wants hyperinflation. But what if inflation were
only 15 percent per year? Haven’t countries grown fast over a period of
time despite high inflation2 The answer is yes, but perhaps
they could have grown faster with low inflation.2 After all, the
variability of inflation increases with its level, as does the
dispersion of prices from their fundamental value in the economy. This
makes price signals more confusing – is the price of my widget going up
because of high demand or because of high generalized inflation? In the
former case, I can sell more if I produce more, in the latter case I
will be left with unsold inventory. Production and investment therefore
become more risky.
Moreover, high and variable inflation causes lenders to demand a
higher fixed interest rate to compensate for the risk that inflation
will move around (the so-called inflation risk premium), thus raising
the cost of finance. The long term nominal (and real) interest rates
savers require rises, thus making some long-duration projects
prohibitively costly.
These effects kick in only when inflation is noticeably high. So it
is legitimate to ask, “At what threshold level of inflation does it
start hurting growth?” Unfortunately, this question is hard to answer –
developing countries typically have higher inflation, and developing
countries also have higher growth. So one might well find a positive
correlation between inflation and growth, though this does not mean more
inflation causes more growth. For this reason, the literature on
estimating threshold effects beyond which inflation hurts growth is both
vast as well as inconclusive. Most studies find that double digit
inflation is harmful for growth but are fuzzier about where in the
single digits the precise threshold lies.3
The Inflation Target
Nevertheless, given the limited evidence, why do most countries set
their inflation goal in the low single digits – 2 to 5 percent rather
than 7 to 10 percent? Three reasons come to mind. First, even if
inflation is at a moderate level that does not hurt overall growth, the
consequences of inflation are not evenly distributed. While higher
inflation might help a rich, highly indebted, industrialist because his
debt comes down relative to sales revenues, it hurts the poor daily wage
worker, whose wage is not indexed to inflation.4 Second,
higher inflation is more variable. This raises the chance of breaching
any given range around the target if it is set at a higher level. To the
extent that a higher target is closer to the threshold, this makes it
more likely the country will exceed the threshold and experience lower
growth. Third, inflation could feed on itself at higher levels – the
higher the target, the more chances of entering regions where inflation
spirals upwards.
The received wisdom in monetary economics today is therefore that a
central bank serves the economy and the cause of growth best by keeping
inflation low and stable around the target it is given by the
government. This contrasts with the earlier prevailing view in economics
that by pumping up demand through dramatic interest rate cuts, the
central bank could generate sustained growth, albeit with some
inflation. That view proved hopelessly optimistic about the powers of
the central bank.
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 you
can fool all of the people only some of the time. If the economy is
producing at potential, we would quickly see shortages and a sharp rise
in inflation. People will also start expecting the central bank to
disregard inflation (that is, be hopelessly dovish according to the bird
analogies that abound) and embed high inflationary expectations into
their decisions, including their demand for higher wages. If contrary to
expectations, the central bank is committed to keeping inflation under
control, it 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 potential
supply so that inflation remains moderate, and the other factors that
drive growth, such as good governance, can take center stage.5
Put differently, when people say “Inflation is low, you can now turn
to stimulating growth”, they really do not understand that these are two
sides of the same coin. The RBI always sets the policy rate as low as
it can, consistent with meeting its inflation objective. Indeed, the
fact that inflation is fairly close to the upper bound of our target
zone today suggests we have not been overly hawkish, and were wise to
disregard advice in the past to cut more deeply. If a critic believes
interest rates are excessively high, he either has to argue the
government-set inflation target should be higher than it is today, or
that the RBI is excessively pessimistic about the path of future
inflation. He cannot have it both ways, want lower inflation as well as
lower policy rates.
At the same time, the RBI does not focus on inflation to the
exclusion of growth. If inflation rises sharply, for instance, because
of a sharp rise in the price of oil, it would not be sensible for a
central bank to bring inflation within its target band immediately by
raising interest rates so high as to kill all economic activity.
Instead, it makes sense to bring inflation back under control over the
medium term, that is, the next two years or so, by raising rates
steadily to the point where the bank thinks it would be enough to bring
inflation back within the target range. Let me emphasize that this is
not a prediction of either the path of oil prices or a forecast of our
monetary actions, lest I read in the paper tomorrow “RBI to raise
rates”. More generally, the extended glide path over which we are
bringing inflation in check appropriately balances inflation and the
need for reasonable growth.
Arguments against what we are doing
There are many who believe we are totally misguided in our actions.
Let me focus on four criticisms. First, we focus on the wrong index of
inflation. Second, we have killed private investment by keeping rates
too high. Somewhat contradictorily, we are also hurting the pensioner by
cutting rates too sharply. Third, monetary policy has no effects on
inflation when the economy is supply constrained, so we should abandon
our attempt to control it. Fourth, the central bank has little control
over inflation when government spending dominates (what in the jargon is
called “fiscal dominance”).
The Wrong Index
Historically, the RBI targeted a variety of indicators, putting a lot
of weight on the Wholesale Price Inflation (WPI). Theoretically,
reliance on WPI has two problems. First, what the common citizen
experiences is retail inflation, that is, Consumer Price Inflation
(CPI). Since monetary policy “works” by containing the public’s
inflation expectations and thus wage demands, Consumer Price Inflation
is what matters. Second, WPI contains a lot of traded manufactured goods
and commodity inputs in the basket, whose price is determined
internationally. A low WPI could result from low international
inflation, while domestic components of inflation such as education and
healthcare services as well as retail margins and non-traded food are
inflating merrily to push up CPI. By focusing on WPI, we could be
deluded into thinking we control inflation, even though it stems largely
from actions of central banks elsewhere. In doing so we neglect CPI
which is what matters to our common man, and is more the consequence of
domestic monetary policy.
The Effective Real Interest Rate, Investments, and Savings
Of course, one reason critics may advocate a focus on WPI is because
it is low today, and thus would mean low policy rates. This is
short-sighted reasoning for when commodity prices and global inflation
picks up, WPI could well exceed CPI. There is, however, a more subtle
argument; the real interest rate is the difference between the interest
rate a borrower pays and inflation – it is the true cost of borrowing in
terms of goods like widgets or dosas. If policy interest rates are set
to control CPI, they may be too high for manufacturers who see their
product prices appreciating only at the WPI rate. I am sympathetic to
the argument, but I also think the concern is overblown. Even if
manufacturers do not have much pricing power because of global
competition, their commodity suppliers have even less. So a metal
producer benefits from the fall in coal and ore prices, even though they
may not get as high a realization on metal sales as in the past. The
true measure of inflation for them is the inflation in their profits,
which is likely significantly greater than suggested by WPI.
A second error that is made is to attribute all components of the
interest rate paid by the borrower to monetary policy. For heavily
indebted borrowers, however, a large component of the interest rate they
pay is the credit risk premium banks charge for the risk they may not
get repaid. This credit risk premium is largely independent of where the
RBI sets its policy rate.
So when someone berates us because heavily indebted industrialists
borrow at 14% interest with WPI at 0.5%, they make two important errors
in saying the real interest rate is 13.5%. First, 7.5% is the credit
spread, and would not be significantly lower if we cut the policy rate
(at 6.5% today) by another 100 basis points. Second, the inflation that
matters to the industrialist is not the 0.5% at which their output
prices are inflating, but the 4% at which their profits are inflating
(because costs are falling at 5% annually). The real risk free interest
rate they experience is 2.5%, a little higher than elsewhere in the
world, but not the most significant factor standing in the way of
investment. Far more useful in lowering borrowing rates is to improve
lending institutions and borrower behavior to bring down the credit risk
premium, than to try and push the RBI to lower rates unduly.
The policy rate in effect plays a balancing act. As important as real
borrowing rates for the manufacturer are real deposit rates for the
saver. In the last decade, savers have experienced negative real rates
over extended periods as CPI has exceeded deposit interest rates. This
means that whatever interest they get has been more than wiped out by
the erosion in their principal’s purchasing power due to inflation.
Savers intuitively understand this, and had been shifting to investing
in real assets like gold and real estate, and away from financial assets
like deposits. This meant that India needed to borrow from abroad to
fund investment, which led to a growing unsustainable current account
deficit.
In recent years, our fight against inflation also meant the policy
rate came down only when we thought depositors could expect a reasonable
positive real return on their financial savings. This has helped
increase household financial savings relative to their savings in real
assets, and helped bring down the current account deficit. At the same
time, I do get a lot of heart-rending letters from pensioners
complaining about the cut in deposit rates. The truth is they are better
off now than in the past, as I tried to explain in a previous lecture,
but I can understand why they are upset when they see their interest
income diminishing.
The bottom line is that in controlling inflation, monetary policy
makers effectively end up balancing the interests of both investors and
savers over the business cycle. At one of my talks, an industrialist
clamored for a 4% rate on his borrowing. When I asked him if he would
deposit at that rate in a safe bank, leave alone invest in one of his
risky friends, he said “No!” Nevertheless, he insisted on our cutting
rates significantly. Unfortunately, policy makers do not have the luxury
of inconsistency.
Supply Constraints
Food inflation has contributed significantly to CPI inflation, but so
has inflation in services like education and healthcare. Some argue,
rightly, that it is hard for RBI to directly control food demand through
monetary policy. Then they proceed, incorrectly, to say we should not
bother about controlling CPI inflation. The reality is that while it is
hard for us to control food demand, especially of essential foods, and
only the government can influence food supply through effective
management, we can control demand for other, more discretionary, items
in the consumption basket through tighter monetary policy. To prevent
sustained food inflation from becoming generalized inflation through
higher wage increases, we have to reduce inflation in other items.
Indeed, overall headline inflation may have stayed below 6 percent
recently even in periods of high food inflation, precisely because other
components of the CPI basket such as “clothing and footwear” are
inflating more slowly.
Fiscal Dominance
Finally, one reason the RBI was historically reluctant to lock itself
into an inflation-focused framework is because it feared government
over-spending would make its task impossible. The possibility of fiscal
dominance, however, only means that given the inflation objective set by
the government, both the government and the RBI have a role to play. If
the government overspends, the central bank has to compensate with
tighter policy to achieve the inflation objective. So long as this is
commonly understood, an inflation-focused framework means better
coordination between the government and the central bank as they go
towards the common goal of macro stability. I certainly believe that the
responsible recent budget did create room for the RBI to ease in April.
Pragmatic Inflation Focus
As you will understand from all that I have been saying, monetary
policy under an inflation focused framework tries to balance various
interests as we bring inflation under control. In doing so, we have to
have a pragmatic rather than doctrinaire mindset. For example, emerging
markets can experience significant capital inflows that can affect
exchange rate volatility as well as financial stability. A doctrinaire
mindset would adopt a hands-off approach, while the pragmatic mindset
would permit intervention to reduce volatility and instability.
Nevertheless, the pragmatic mind would also recognize that the best way
to obtain exchange rate stability is to bring inflation down to a level
commensurate with global inflation.
Similarly, while financial stability considerations are not
explicitly in the RBI’s objectives, they make their way in because the
RBI has to keep growth in mind while controlling inflation. So if the
RBI’s monetary policies are contributing to a credit or asset price
bubble that could lead to a systemic meltdown and growth collapse, the
RBI will have to resort to corrective monetary policy if
macro-prudential policy alternatives are likely to prove ineffective.
The Transition to Low Inflation
The period
when a high inflation economy moves to low inflation is never an easy
one. After years of high inflation, the public’s expectations of
inflation have been slow to adjust downwards. As a result, they have
been less willing to adjust their interest expectations downwards.
Household financial savings are increasing rapidly as a fraction of
overall household savings, but not yet significantly as a fraction of
GDP.6 Some frictions in the interest rate setting market do
not also help. Even while policy rates are down, the rates paid by the
government on small savings are significantly higher than bank deposit
rates, as are the effective rates on tax free bonds. I am glad the
government has decided to link the rates on small savings to government
bond rates, but these rates will continuously have to be examined to
ensure they do not form a high floor below which banks cannot cut
deposit rates. All in all, bank lending rates have moved down, but not
commensurate with policy rate cuts.
The wrong thing to do at such times is to change course. As soon as
economic policy becomes painful, clever economists always suggest new
unorthodox painless pathways. This is not a problem specific to emerging
markets, but becomes especially acute since every emerging market
thinks it is unique, and the laws of economics operate differently here.
In India, at least we have been consistent. Flipping through a book of
cartoons by that great economist, RK Laxman, I found one that indicated
the solution for every ill in 1997 when the cartoon was published, as
now, is for the RBI to cut interest rates by a hundred basis points.
Arguments change, but clever solutions do not.
Decades of studying macroeconomic policy tells me to be very wary of
economists who say you can have it all if only you try something out of
the box. Argentina, Brazil, and Venezuela tried unorthodox policies with
depressingly orthodox consequences. Rather than experiment with
macro-policy, which brings macro risks that our unprotected poor can ill
afford, better to be unorthodox on microeconomic policy such as those
that define the business and banking environment. Not only do we have
less chance of doing damage if we go wrong, but innovative policy may
open new paths around old bottlenecks. Specifically, on its part the RBI
has been adopting more liberal attitudes towards bank licensing,
towards financial inclusion, and towards payment technologies and
institutions in order to foster growth.
Institution Building
Let
me return to institution building. We had gotten used to decades of
moderate to high inflation, with industrialists and governments paying
negative real interest rates and the burden of the hidden inflation tax
falling on the middle class saver and the poor. What is happening today
is truly revolutionary – we are abandoning the ways of the past that
benefited the few at the expense of the many. As we move towards
embedding institutions that result in sustained low inflation and
positive real interest rates, this requires all constituencies to make
adjustments. For example, if industrialists want significantly lower
rates, they have to support efforts to improve loan recovery so that
banks and bond markets feel comfortable with low credit spreads. The
central and state governments have to continue on the path of fiscal
consolidation so that they borrow less and thus spend less on interest
payments. Households will have to adjust to lower nominal rates, but
must recognize that higher real rates make their savings more
productive. They will find it worthwhile to save more to finance the
enormous investment needs of the country.
Adjustment is difficult and painful in the short run. We must not get
diverted as we build the institutions necessary to secure a low
inflation future, especially because we seem to be making headway. The
Government has taken the momentous step of both setting a CPI based
inflation objective for the RBI as well as a framework for setting up an
independent monetary policy committee. In the days ahead, a new
governor, as well as the members of the committee will be picked. I am
sure they will internalize the frameworks and institutions that have
been set up, and should produce a low inflation future for India.
The rewards will be many. Our currency has been stable as investors
have gained confidence in our monetary policy goals, and this stability
will only improve as we meet our inflation goals. Foreign capital
inflows will be more reliable and increase in the longer maturity
buckets, including in rupee investments. This will expand the pool of
capital available for our banks and corporations. The government will be
able to borrow at low rates, and will be able to extend the maturity of
its debt. The poor will not suffer disproportionately due to bouts of
sharp inflation, and the middle class will not see its savings eroded.
All this awaits us as we stay the course. Thank you very much for your
patience in listening to me.
References
Bruno Michael and William
Easterly. 1995. "Inflation Crises and Long-Run Growth," NBER Working
Paper No. 5209 (Cambridge, Massachusetts: National Bureau of Economic
Research).
Easterly William and Stanley Fischer. 2001. “Inflation and the Poor.”
Journal of Money, Credit and Banking. Volume 33, Issue 2. May. 160-178
Fischer Stanley 1993. “The Role of Macroeconomic Factors in Growth”.
Journal of Monetary Economics. Volume 32, Issue 3, December 1993, Pages
485-512
Khan, Mohsin S., and Abdelhak S. Senhadji. 2000. "Threshold Effects
in the Relationship Between Inflation and Growth," IMF Working Paper
00/110 (Washington: International Monetary Fund).
1 Foundation Day Lecture of Dr. Raghuram G. Rajan, Governor, Reserve
Bank of India, at Tata Institute of Fundamental Research, June 20, 2016,
Mumbai.
2 In fact, in a seminal paper, Fischer (1993) presents cross-country
evidence to show that growth is negatively associated with inflation,
and the causality runs from inflation to growth.
3 For example, Bruno and Easterly (1995) suggest 40 percent as a
danger point, beyond which increases in inflation are very likely to
lead to a growth crisis. In contrast, Khan and Senhadji (2000) estimate
that the threshold above which inflation significantly slows growth is
1-3 percent for industrial countries and 7-11 percent for developing
countries.
4 According to Easterly and Fischer (2001), “a growing body of
literature on balance—but not unanimously—tends to support the view that
inflation is a cruel tax”.
5 I am being a bit loose here. The short run tradeoff works because
economic actors can be surprised by unexpected loosening, and the
surprise can have positive growth effects. In the long run, the central
bank loses its power to surprise, and the public embeds its correct
forecast of how much inflation the central bank will create into all
nominal variables such as interest rates. To the extent that high
inflation is harmful for growth and welfare, a central bank that
continuously tries to give short run positive surprises will entrench
long run high inflation, which will be bad for growth.
6 Data from household surveys also suggest that household financial
savings are moving up. For example, two recent financial inclusion
surveys for selected states in India - Financial Inclusion Insights
survey conducted by InterMedia and the FinScope survey implemented by
the Small Industries Development Bank of India (SIDBI) - suggest that
among individuals “who have a bank account”, the fraction who saved
through bank deposits increased from 60% in 2013 to 98% in 2015. Of
those who “save money”, the fraction saving through a bank increased
from 67% in 2013 to 93% in 2015. Of those who “save money”, the fraction
“saving at home” has declined dramatically from 90% in 2014 to 6% in
2015.
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