Retrofitting the Reserve Bank
John Maynard Keynes was surely right to remark that the world is ruled by ideas and little else. But he may have been optimistic in believing that “soon or late, it is ideas, not vested interests, which are dangerous for good or evil."Actually, vested interests can ensure that ideas prevail even when they are meant to serve some sectional interests at the cost of others. To those convinced of the infallibility of the principles governing the creation of wealth it must come as a surprise that some of what is often considered knowledge in the context may be contested on perfectly reasonable grounds or, worse still to their likely horror, merely reflects the interests of certain parties to the transaction, so to speak. This is certainly true of the reigning view of the role of the central bank. Central banks are pivotal to the economic system and all countries have them. Our own Reserve Bank of India is widely admired as arguably the last institution standing up to the machinations of the political class. It has certainly helped that every Indian to have headed it has represented the highest traditions of public service and personal integrity. Persons apart, however, a certain degree of morphing of the RBI has occurred of late, some of it deliberately intended and some of it perhaps in the form of collateral damage.
The Finance Bill 2016 has finally succeeded in making inflation targeting the sole objective of monetary policy. As monetary policy is the central bank’s prerogative, the move may be welcomed as signaling a newly minted and whole-hearted commitment to inflation control which is now privileged over all other objectives. It, however, overlooks two possibilities that are surely of relevance in the context. First, whether the focus on inflation may imply a loss in certain other areas of the economy. And, secondly, whether, inflation is fully within the its control anyway. Each of these considerations pose substantial questions.
The issue germane to the first is whether focusing on inflation can lead to preventing a rise in employment. In economies with unemployed resources an increase in aggregate demand may be expected to lead to a rise in output and a rise on prices if there is a shortage of some inputs into production. In India the rise in prices is usually that of food some items of which have been perennially in short supply, the case of pulses and vegetables coming to mind immediately. Note that the increase in output may be expected to lead to an increase in employment as goods require labour for their production. Thus we have an increase in output, employment and prices. In a situation of ongoing inflation, we may even witness a rise in its rate. The question now is how to deal with the rise in prices. This can be done via one of two approaches.
Under so called inflation targeting the central bank raises the rate of interest. When this is passed on by the commercial banks it reduces the demand for credit, lowers investment and output growth. There is a concomitant reduction in the demand for labour and the offending material inputs whose price rise constituted the inflation. Inflation is now likely to reduce. But notice the accompanying reduction in output. Supporters of inflation targeting argue that the initial spurt in output would not have been sustainable anyway as in the ‘long run’ workers will withdraw labour when they find that inflation has eroded the real value of their wages. This claim is sustained by ruling out involuntary employment, defined as a situation where workers are ready to work at the given money wage but do not find jobs. In its essence, the policy of inflation targeting assumes that the economy is always at full employment or the ‘natural rate’ in the modern economist’s vocabulary. In this account fully-employed workers offer more labour as inflation rises only because they mistake an increase in their money wage for a rise in its purchasing power i.e., they are unaware of the inflation. This suggests a certain credulousness among workers who, one would imagine, visit the bazaar on their way home from work in the evenings. It is only by insisting that inflation always and everywhere reflects employment having overshot its natural rate that the claim of no loss in welfare due to tight monetary policy can be sustained.
It should be clear by now that inflation targeting by the central bank can stem inflation due to supply shortages only by restricting demand. This entails welfare loss as employment is thereby reduced. So, how are we to deal with the inflation of the type described above, which I suggest is typical of India today? It can only be tackled via an expansion of the supply shortfall through either imports or increased production. We would then have tackled inflation at source i.e., directly, not indirectly, by restricting aggregate demand, as under a policy of inflation targeting. As a defence of the latter is offered the idea that the central bank can influence inflation expectations by signaling its intent to lower inflation in the future. But why should agents buy this when they know that the bank cannot influence the food supply, which is the source of inflation? Their expectation of inflation is likely to remain high if they do not see perceive in the offing a radical change in the supply position. By suggesting via the Finance Bill that now that inflation targeting becomes the sole objective of monetary policy in India, the Government of India has not just oversimplified the problem of inflation control, it has also shut out of the reckoning an assault on India’s weak agricultural supply-side. The importance of a strong supply position in combatting inflation can be seen from the history of the US and the UK in the last four decades. Following the oil-price hikes of the seventies these economies went into overdrive in reducing their dependence on imported oil, the price of which could be manipulated by a cartel such as OPEC. This was achieved through a combination of supply and demand-side measures. The UK was lucky in striking oil in the North Sea while the US developed an alternative to crude oil from shale. What is less well known is that there has also been a concerted conservation drive, something that we have not seriously attempted as India’s politicians are reluctant to propose any form of belt tightening.
Far from being an open and shut case then, the adoption of inflation targeting as the sole objective of the RBI is contestable in ways that have been indicated here. It also ignores a serious lesson from the recent global financial crisis which is that an inflation targeting central bank can lose control of financial system. This after all was what had happened in the US that had enjoyed a “great moderation” of inflation even as banks were generating toxic assets with the capacity of dragging the system down. It is not sufficiently recognised that at least some part of the present problem of non-performing assets in India is related to poor lending by the nationalised banking sector at a time when inflation was considered to be under control. If a central bank is to have responsibility for financial stability, and this was the original task assigned to it, its focus cannot be exclusively on inflation. In India the Financial Development and Stability Committee has taken the task of financial regulation outside the RBI. This is unwise, as the interest rate mechanism can prove to be a double-edged sword. While it may curb inflation when raised it may at the same time threaten financial stability by tipping indebted entities into insolvency. There is no case for monetary policy and financial regulation to not be under the same authority.
But what about the vested interests that I started out talking about? They are present as follows. Inflation lowers the real value of fixed- income securities referred to as ‘bonds’. Bond holders thus face ‘inflation risk’. As the total value of these securities rises in an economy a vested interest in keeping inflation low emerges. Wall Street in the United States is the archetype here. Its interests are not that of the American worker i.e., it only cares about the real value of the financial wealth it manages. It is also powerful, reflected by the revolving door between Wall Street and the United States Treasury, the equivalent of our ministry of finance. However, not even this has succeeded in turning the Federal Reserve into an inflation-targeting central bank. It’s mandate includes “promoting maximum employment”. The Indian establishment, on the other hand, has shown itself to be amenable to cognitive capture.