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Can higher interest rates tame India's food inflation? -Dipak Dasgupta
-The Business Standard


The challenge to anti-inflation policy lies in better institutions and better evidence-based policy

Our failure to rein in inflation has been costly. Economically, it has hurt growth. Poor and urban middle-class households have been affected the most. A combination of slowing growth and high inflation has weakened our macro-fundamentals: households fled financial savings, domestic and foreign investors lost confidence, and the rupee plunged. Politically, it has been a disaster.

For six long years since 2007, we have lived with persistent double-digit food inflation, and in turn, high consumer price (CPI) and wholesale (WPI) inflation. Food and non-food inflation are linked. Although peak inflation rates may have come down, the pace of reduction was glacial.

What explains this current episode of persistently high inflation in India? And is tight monetary policy the answer - as the latest increase in the RBI's policy repo rate by 25 basis points, and the Governor's statement, appear to suggest? Unlikely. What the past 14 interest rate hikes failed to do can't possibly succeed with one more. Although markets put a brave face forward, the RBI's action on January 28 - after skipping a hike in December - was actually aimed at protecting the rupee against renewed emerging-market currency pressures.

The question that the RBI should have addressed is: why is consumer inflation so persistently high in India, and what might we do to bring it down? The RBI 'target' of eight per cent inflation by 2015 may likely be achieved, but is unacceptable and unimaginative. There are only a few comparators, such as Angola, Burundi, Nigeria, Egypt, and our neighbours, Iran, Bangladesh, Pakistan and Nepal, who share such high inflation. Brazil, China and Indonesia, middle-income countries, have about five to six per cent inflation; high-income countries about two to three per cent; and the low-income average is about seven per cent - much lower than our near-10 per cent.

The RBI, together with the policy research community, needs to build an analytically rigorous and empirically credible explanation for this high inflation episode. Our international advisers, the IMF, the World Bank and the ADB, have not found much analytically helpful either. Instead, what we have are conjectures and bits of evidence, and one too many conflicting explanations: from monetary policy transmission lags and ineffectiveness, 'behind the curve' policy, and uncoordinated fiscal and monetary policy to supply bottlenecks, rising consumer demand, shift to proteins, sudden price spikes, wholesale cartels, international food and energy prices, weather shocks, sharply rising MSPs (Minimum Statutory Prices), and 'hard-to-shake' inflation expectations.

A new government will benefit from better evidence-based policy. Let's start with fiscal. Cutting much useless spending would be both pro-growth and pro-low-inflation. We need to examine policy choices: is RBI's eight per cent consumer inflation and 5.5 per cent growth by 2015 the only choice? Or, might India be more ambitious, five per cent inflation and eight per cent growth by 2016, with key fiscal ingredients? Among other fiscal steps, stop raising MSPs sky-high, season after season, they are floor prices, and release PDS stocks counter-cyclically - strong econometric evidence supports both.

Is tight monetary policy the answer? When we sieve the econometric evidence, high nominal interest rates appear to be a driver of high consumer and food inflation episodes, reversing cause and effect. Why? Because tomorrow's (futures) food prices are driven by today's interest rates over current prices the world over - not surprising, since interest costs dominate storage costs and decisions.

Then deal with structural supply-side factors. Announcing a PM-appointed Inter-Ministerial Group or a Committee of Secretaries on inflation is not useful since there is serious incentive-incompatibility. Instead, deal directly with well-known periodic price shocks in onions, tomatoes and other perishables that have spillover price effects on other commodities, and product markets with significant large-actor collusive potential such as milk and eggs. These markets are subject to periodic upward swings, triggered by weather or other supply disruptions, allowing oligopolistic and predatory market behaviour by large agents, where government is often complicit. During the past five years, we have had several such episodes, the most recent last October.

Deal better with global commodity price cycles in commodities such as edible oils, cotton and sugar, where India is a large player. Use variable tariffs counter-cyclically, pre-set with explicit price triggers (and not subject to the whims and decisions of another committee, by which time the marketing season is over). Other countries have built such institutions which do this well all the time. It is time that we re-examine the mandate, staffing and accountability of our existing price policy institutions.

Between 1991 and 2013, consumer inflation in India averaged eight per cent a year. Remarkably, between 1999 and 2005, we had much lower food inflation - four per cent a year. The rest of the time, we averaged about nine per cent a year. When we plug the four main categories of explanations given above, our 'predicted' price inflation model works reasonably well throughout the period, giving us greater confidence.

At the end of the day, the challenge to anti-inflation policy lies in better institutions, better evidence-based policy, and greater accountability. The reason that India has such persistently high consumer inflation is an institutional failure. Let's hope the next government will ask the RBI and other agencies to reconsider their old and failing approaches. I am convinced that persistently high consumer inflation over the past six years in India has had very little to do with excess aggregate demand (corroborated by faster supply, bulging stocks and booming exports), and is not amenable to some monetary policy 'quick-fix'.

The writer is former Principal Economic Adviser, Ministry of Finance, and former Lead Economist for India and South Asia, World Bank