Macroeconomic Mess 101

Op-ed in the Business Standard, New Delhi

June 27, 2008

The Indian policy response to inflation has been somewhere between poor and awful.

Yes, India has a global inflation problem because world demand, especially for commodities, is running ahead of world capacity. The phenomenon is global but policy responses will be national.

So, which countries are going to act decisively to curtail demand? Of the three economically significant global players-the United States, the European Union, and China-it is only the European Union that has kept demand in check through relatively tight monetary policy. The United States and China have not. The United States, in order to preserve its financial system and avoid a slowdown, has followed expansionary monetary and fiscal policies, aggravating global price pressures, and while China has tightened, it has been small in magnitude and done with reluctance because any serious slowdown to the Chinese growth juggernaut is anathema to the Party.


Wholesale Price Index and Monetary Conditions Index (MCI)
Index based on weighted average of nominal interest rates and exchange rate, with weights of two-thirds and one-thirds, respectively.
figure 1

What does this imply for India? While it is convenient, but no less accurate for that reason, to ascribe the origins of recent problems to external forces, Indian policymakers have to move on. First, these external inflationary impulses are not going to be corrected externally: For the reasons described above, neither the United States nor China is going to act forcefully and quickly enough to provide relief for the average Indian consumer. Moreover, India has moved to the second round, where the initial external supply shock has started affecting domestic prices across the board. In other words, India now has a domestic inflation problem, which requires domestic policy action.

And yet, what have we seen in India? Leave aside the obligatory and unhelpful tampering (trade and price controls) at the microeconomic level. On the macro front, apart from the relatively modest hike in petroleum prices, the Indian policy response has been, well, somewhere between poor and awful, meriting a grade of about 2 out of 10.

Consider how fiscal, monetary, and exchange rate policies have not just been inadequate, they have gone in the wrong direction.

The fiscal position is deteriorating, and substantially, at a time of accelerating inflation. One estimate is that the true central government fiscal deficit could deteriorate this year by a whopping 2.5 to 3 (at a minimum) percentage points of GDP thanks to a combination of the loan waivers, pay hikes, fertilizer subsidies, and above all, automatic destabilizers. By fixing retail prices for petroleum, government spending and the deficit automatically increase when oil prices rise, aggravating inflationary pressures. How sensible is that?

A lot has been written about petroleum pricing policy. Three points, however, bear repetition. Indian petroleum pricing, like that of China and the United States, acts to maintain high world oil prices, and to turn the terms-of-trade against India. This is self-inflicted harm, made worse by the fact that the beneficiaries of Indian policy are countries whose direct and indirect influence on India is far from benign. Second, fixed retail prices are implemented in the name of equity and end up being bad not just for efficiency but also equity: Petroleum consumers are richer than the average Indian, who pays for the consumption of the rich through a combination of higher taxes and/or inflation caused by oil subsidies. But a third, and possibly important point as we look ahead relates to climate change. India, like other developing countries, justifiably rails against the rich world for having caused global warming. But India will simply not be a credible or cooperative global partner in the fight against this problem, and India's legitimate complaints against the rich risk being dismissed as hypocrisy, if its policy contribution is to encourage rather than discourage fuel consumption.

Monetary and exchange rate policies in these last few months have both been mystifyingly inadequate. In late February, a chorus of respected voices in India unanimously rounded upon the Reserve Bank of India (RBI) for not lowering interest rates when the golden opportunity of US rate-cutting presented itself. The RBI added considerably to its sheen by presciently citing the threat of inflationary pressures as the reason for its inaction. It was right and the commentators wrong. Having displayed its anti-inflationary mettle then, it came as a surprise when in the period since mid-April, the RBI countenanced an exchange rate depreciation at a time of imported inflationary pressures. To be fair, there has been some tightening of the cash reserve ratio and repo rates, especially in the last few days. But: (i) these have been small and delayed; (ii) the key reverse repo rate, which is arguably the real lever for the RBI to manipulate monetary conditions under conditions of excess liquidity, has remained unchanged at 6 percent compared to current inflation of 11 percent; and (iii) above all, combining the tepid monetary actions with the sizable rupee depreciation yields the conclusion that overall monetary conditions, far from having tightened, may actually be looser at a time of accelerating inflationary pressures. The accompanying chart computes a simple monetary conditions index, and it is striking how prices and monetary policies have diverged in the recent past, and how even the most recent rate hikes may be inadequate to counter price pressures.

Thus, from an inflation perspective, India has destabilizing rather than stabilizing fiscal and monetary policies. There is a real mystery here because electoral populism cannot easily explain these policies; after all, high, especially double-digit, inflation is considered electorally fatal for incumbent politicians, and RBI policymaking has always reflected that political reality.

It is true that tightening will slow growth, but at 11 percent inflation and 9 percent growth, the politically expedient trade-off would have been to sacrifice some growth for lower inflation, especially since there is a plausible case that at a 9 percent growth, India is testing the limits of the economy's capacity. Why aren't politicians behaving like politicians? Why is the RBI not being true to its inflation hawk credentials?

In India, political opportunism is ritually invoked to exonerate bad policies. In the current circumstances, even this cynical explanation seems inadequate. Good economics is proving elusive even when it is reasonable politics.

The author is senior fellow at the Peterson Institute for International Economics and the Center for Global Development and is senior research professor at Johns Hopkins University. His book, India's Turn: Understanding the Economic Transformation (Oxford) has just been published.