EA’s concerns on CPI-targeting right, but too late
It is interesting that chief economic advisor Arvind Subramanian should be raising concerns about RBI using CPI as the target variable for inflation-targeting—“At the rate of?”, The Indian Express, June 12 (goo.gl/3HFD9p)—since, apart from being against an inflation-targeting framework, FE has been arguing against using the CPI for well over a year and a half. While the slowing growth and capacity utilisation in the economy was getting reflected in the falling WPI over the last few years, the problem was the CPI was not capturing it—nor was the RBI’s Expectations Survey. In such a situation, focusing on CPI was always a bad idea. Indeed, one of the fundamental premises of inflation-targeting, that households need a positive real rate of interest to save more in financial instruments, also looks incorrect since past episodes of negative interest rates have not resulted in savings—and within this, financial savings— falling. Bank deposit rates in FY10, for instance, were around half the CPI inflation rate, but that was the year household financial savings touched a record high of 12% of GDP. If this collapsed in FY12, this was probably related to the fact that gold gave its best returns of 33.8% in that year—the data suggests savings are more a function of income or GDP growth than of real rates of interest.
Subramanian has, not surprisingly, been criticised by Rajeev Malik in yesterday’s FE since it was just 4 months ago that the finance ministry inked its CPI-based monetary policy framework with RBI—surely the CEA should have advised against it? While Malik finds Subramanian’s case for a blended WPI/CPI metric weak for a variety of reasons (goo.gl/1i5dMS), as FE columnist Renu Kohli—at the forefront of the anti-inflation-targeting argument—points out, we are in a situation where the GDP deflator may have turned negative. If that situation persists, and Kohli’s argument is that it well might, this will have large implications as far as government spending is concerned—this is defined in nominal terms which may not get realised if the deflator is low (goo.gl/e7GBBl). The fundamental question that policymakers need to address is why the WPI continues to diverge from the CPI—since 2012—in the manner it has, and what is the reason behind WPI being negative for the last 7 months, including three in which even core WPI has been negative. Most analysts brush this away with the argument that it is due to the global collapse in raw material prices and this will get fixed over the next few months—that, however, is not clear since Chinese growth continues to slip.
More important, if raw material prices have collapsed in the manner they have but corporate profits are as poor as they are, this means the demand impulse in the economy is a lot weaker than it looks—which is why, a day after finance minister Arun Jaitley talked of the jump in indirect tax collections, Subramanian chose to be more circumspect. Indeed, as the CEA has pointed out, based on the GDP-deflator, real rates are in the 7.5% range—who is going to invest at such rates? There are related problems that will come up should the WPI not start picking up—debt burdens get more onerous when inflation is low. There are also other issues like the huge supply-chain constraints that could be behind the CPI-WPI disconnect and which can get aggravated as growth picks up. Though RBI can do little to fix supply-chain issues which, as Malik argues, could be real problem, in such a situation, the last thing the government should have done was to agree to limit its policy options with an inflation-targeting framework.