"Inflation targeting does not lift growth", 'Business Line', December 29, 2014

Who will anchor profit expectations?

For about three years now high inflation amidst slowing growth has been the principal concern of India’s finance ministers. Inflation is by now trending downward though, which has perhaps come as a breather to the present one. This respite from fire-fighting should be used to reflect on what drives inflation in India in the first place and how it is related to growth. However, instead of such  reflection we find a two-part response which evades these questions altogether. The first part is to repeat the homily that inflation is detrimental and needs to be controlled. The second asserts that the route to its control is to adopt ‘inflation targetting’. Neither statement can be accepted unconditionally. First, if the reduction in inflation comes at the cost of increasing unemployment it would imply that single-minded focus on inflation will be harmful.

            The proposition that lower inflation may be being purchased by higher unemployment is responded to with the assertion that in the long-run there is no trade-off between the two. This response relies entirely on the interpretation of the short-term trade-off as due to workers having forecast inflation wrongly. Accordingly, it is asserted that in the long run – when everything must change at the same rate forever – there can be no trade-off as expectations of inflation will equal the actual rate. The task of economic policy in this view of the world is cut out. It is simply to anchor, as in pin down, the inflationary expectations of the private sector.

            The story just recounted has a problem telling us why inflation is damaging so long as it is anticipated. To make a case for inflation control an excursion outside the model has to be made. It is argued that inflation is detrimental to growth as it introduces uncertainty into the investment decision. In some ways this is a useful extension, without being correct, as it leads us closer to the situation in the real world where almost everything is driven by the investment decisions of firms and not by the labour supply decisions of workers. After all, the demand for labour is a derived demand.

            Growth is driven by investment. However, the investment decision of firms is plagued by a form of uncertainty far more challenging than the possibility of inflation. It is based on the expectation of profit. This expectation is in turn based on the anticipated state of the economy in the future. A firm’s revenues are closely tied to the demand for its product which is really a subset of aggregate demand in the economy. Therefore, if the firm does not anticipate a buoyant economy it is unlikely to invest today whatever be the expected inflation rate. It is not at all clear how pegging the inflation rate into the future, which is what anchoring inflationary expectations amounts to, can do to fix this problem. Steady or zero inflation today does not obviate the relevance of anticipated aggregate demand to a firm’s investment decisions. In fact, depending upon how the inflationary expectations are fixed, anchoring them could actually lower growth.

            In the technical language of finance a firm compares the rate of interest to its internal rate of return. When the internal rate of return is interpreted as the yield of an investment project we can see the meaningfulness of the comparison being made. Now, where the cost of funds is lower than the yield the project is accepted and the firm makes the investment outlay. However, the most impressive sounding ‘internal rate of return’ is just dressed-up expected aggregate demand, as it is based on the expected revenues from the project which the firm bases at least in part on its anticipation of the state of the economy. A lower real of interest, leave alone a lower inflation rate, can do little to revive an economy if agents’ expectations turn pessimistic.

            As always with respect to the design of policy for the economy we must turn to the evidence. The history of the US economy in the past decade is that low inflation is not necessarily a tonic for investment, and thus for the economy. During this period the US has experienced low inflation as part of a larger experience of macroeconomic stability, extolled as ‘The Great Moderation’ by Ben Bernanke, a former governor of the Federal Reserve Bank. But far from this low- inflation environment contributing to a steady growth the housing bubble burst and the US is still living in the he shadow of this collapse. Inflation has been low and steady despite the Fed pumping liquidity into the economy. But, though output has regained the pre-crisis level, there is no sign of major revival of investment.How is this investment behavior to be understood? It can be comprehended in terms of the profit expectation of firms. A lowering of inflationary expectations per se can do little to raise profit expectations. On the other hand, if potential investors imagine that the lower inflation reflects depressed aggregate demand which is to continue into the future they would shelve their investment plans, and collectively precipitate slower growth even if not a depressed economy. So is there a role for policy here? Yes there is, though, as is to be expected, this would be context dependent, in particular dependent upon why investor sentiment is subdued. 

            All of the above is fully relevant to India today. Inflation in India is trending downwards, but this seems to be making little difference to the growth impulse. We can see this as a case of depressed profit expectations. What can the government do to raise the expectation of profit? It can do quite a bit, all of it revolving around aggregate demand. To influence aggregate demand fiscal policy has to be used to return buoyancy to the economy. Again, we can see the possibilities when we go back to the US economy. As the IMF has pointed out fiscal policy in the US has been relatively contractionary since 2008 compared to the past. This is quite extraordinary as the US has experienced the greatest downturn in output since the Great Depression. We now see what accounts for this outrageous policy stance. It is Republican ideology that denies a stabilising role for fiscal policy that is at the centre of events in the US. But India is not far behind. Sheer ignorance about the role of fiscal policy in providing forward guidance means that all is left to the Reserve Bank of India which doggedly attempts to tame inflation while promising.

            The trajectory of growth over the past decade in India is closely tracked by that of public capital formation. Thus, over 2003-08 public investment in infrastructure grew at an unprecedented rate. So did the economy. Public capital formation declined precipitously since 2008, and so did growth. It is not inconceivable that the private sector has internalised this, and now forecasts slow growing profits for itself so long as public capital formation is depressed. If the government is interested in reviving growth it needs to resume greater spending on infrastructure to crowd-in investment as the private sector’s view of the future turns more optimistic. Anchoring profit expectations is as necessary as anchoring inflationary ones.

Pulapre Balakrishnan is Professor, Centre for Development Studies, Thiruvananthapuram.