An irrational expectation of monetary policy

By Pulapre Balakrishnan


Inflation is at the centre of the macroeconomic policy debate today. At such moments it is customary for the Indian policy establishment to look to the RBI for action. The RBI has now raised the repo rate for the 12th time in fifteen months. It has claimed that this is intended to “anchor inflationary expectations”. This buzzword from the more conservative strand of Anglo-American economics may be sufficient to soothe the gullible. The question, however, is whether we have a reasonable expectation of the power of monetary policy to tackle inflation of the kind that we are witnessing. It is apparent from the data that we have a good enough understanding of what lies at the bottom of it. It is mainly the relative price of food. If we partition the time series on inflation from the year 1991-92 to the present to arrive at three 6-year phases over 1992-2011, we would find that the trajectory of inflation over the 3 phases is mimicked by the movement of the relative price of food articles.  We may invest our understanding with some confidence for the inflation rate has actually fluctuated over this period – being lower in the middle phase - and yet the relative price tracks this movement quite faithfully. 

                From the point of view of realistic assessment, short of imports, there is no near-term cure for a food-price driven inflationary process. In terms of a standard analysis we would need agriculture to expand via outward shifts in the supply curve implied by productivity increases. This is the route taken by the west historically.  It has actually led to a declining relative price of food. This form of expansion would require non-price policies such as extending irrigation and strengthening extension, which are yield enhancing. Such a strategy would be non-inflationary. It’s being pursued seriously in India is, however,  hostage to the dictates of political economy, i.e., its beneficial impact comes some years down the line while the electoral cycle is limited to five.

                As we have since 2008 been in a regime of slowing growth and rising inflation it can hardly be claimed that the inflation is due to ‘overheating’.  This recognition gives us an insight into the potential of macroeconomic policy, particularly monetary policy, in the present context. The current inflation is driven by the relative price of food, and money cannot affect relative prices. Therefore the claim that the central bank can smother inflation by anchoring expectations holds no water. Rational expectation – with the term being used in a substantive as not the descriptive mathematical sense  – of the short-run price in a commodity market is governed by expectations of the central authority’s ability and willingness to use stocks. Stocks of pulses and milk the Indian central bank does not possess in any case, and the central government has shown itself to be unwilling to use foodgrain stocks to stabilise prices for fear of alienating the farmers.

                We need to recall how monetary policy works. Administered interest rate changes, among which would count a hike in the repo rate by the RBI, can affect the level of inflation, if at all, only by lowering the rate of growth of output.  It is important to stress that, if cost-plus pricing prevails in industry, the slowing of industrial output growth can have only a marginal impact on industrial price inflation. It may have some impact on foodgrain-price inflation though, as the demand stemming from industrial growth would have slowed. This at any rate is the theory. The recent experience from India, i.e., slowing industrial growth coinciding with rising inflation, suggests that the premise of a monetary-policy cure for an agricultural-price-driven inflation is questionable to say the least.

                The inefficacy of a monetary-policy intervention allegedly aimed at anchoring inflationary expectations is, however, the lesser evil in relation to what it might end-up achieving in the real world.  To appreciate this fully we would need to engage with some propositions put out by the Harvard economist  Robert  Barro. Barro had claimed that, in a world where inflation is determined by variations in money growth engineered by the central bank, agents form their expectation based on the anticipated money growth alone. So when the central bank announces the future rate of growth of money agents all would merely adjust their expectation of inflation accordingly, leaving output growth unchanged. It is not difficult to see that this fanciful account can have little purchase with India’s savvy firms. Where firms base their investment plans on anticipated aggregate output, the source of demand for their own product, an interest rate- based anti-inflation policy would result in lowering output without necessarily lowering the inflation rate. Note that the central bank would have, through its actions, anchored expectations, but of output, and the firms would have been perfectly rational in their anticipation.  This is cold comfort indeed. So the next time you hear it said that we can fix inflation in India if only the RBI were to show a little more resolve be aware of this prospect.  The RBI has raised the repo rate repeatedly since the onset of the current inflation. If there is an episode giving us reason to believe that monetary policy is powerless in the face of a supply-driven inflation “it is this, it is this, it is this”. We need to get real about economics. Public institutions responsible for policy are expected to remain beyond cognitive capture.