Urjit Patel focus on inflation-targeting a bad idea
If CPI inflation continues to fall the way it is—it was 9.87% in December versus 11.16% in November—chances are we will get to the Urjit Patel committee’s first milestone of an 8% CPI within a year. But once you get beyond that first number, into the substance of the report that recommends inflation-targeting as a policy, you run into serious problems. As credit-rating agency Crisil’s chief economist, DK Joshi, points out, if food inflation is to stay at its 10% average for the last 8 years, a 6% CPI inflation target—Patel’s target over the next two years—means non-food inflation has to come down to 2%. For a 4% target, it has to come down to minus 2%—the committee’s long-term view is that the CPI target should be 4% ± 2%.
While Patel wants to move a CPI-based inflation-targeting system, there is insufficient explanation as to what has gone wrong—and why—with the current WPI-anchored multiple-indicator model. The view that high inflation is the reason behind the decline in financial savings also appears hasty. The committee argues that as high inflation makes real interest rates negative, households invest more in gold and less in financial assets; the high gold imports cause a CAD problem and with the rupee going for a toss, this also results in a balance sheet problem for India Inc and the banks that have lent to it. In which case, why haven’t similar past episodes of negative interest rates resulted in savings—and within this, financial savings—falling? Bank deposit rates in FY10 were around half the CPI, but that was the year household financial savings touched a record high of 12% of GDP. If this collapsed in FY12, this is likely related to the fact that gold gave its best returns of 33.8%—in any case, surely the committee doesn’t believe deposit rates need to be hiked to this level?
Also, since negative real interest rates spur investments and raise growth, this causes savings to rise. Which is why, while overall savings rates are down from 36.8% of GDP in FY08 to 30.8% in FY12, household savings have remained steady at 22.4% of GDP—it was India Inc’s savings that fell from 9.4% to 7.2% and the public sector’s from 5% to 1.3%.
The short point is that in a country which has so many supply constraints, the central bank focusing on just inflation control—through interest rate hikes primarily—just isn’t going to work. The Supreme Court banning mining, the environment ministry refusing to clear projects, the government raising wages rates through MGNREGA, APMC-based constraints on trading, FCI buying up grain and keeping 42 million tonnes out of the market … given all these constraints are here to stay, accepting the Patel committee recommendations means interest rates will have to be hiked dramatically to keep CPI inflation at 4-6% levels, and that will have its own consequences for growth, savings and investment levels. If the government is to get its fiscal deficit in order and stop playing ducks and drakes with fixing prices or hoarding grain—Patel’s pre-requisites—then whether or not RBI moves to inflation-targetting, inflation will remain largely under control anyway.